The phrase "life insurance annuity" usually means one thing: someone died, the policy paid out, and the insurer offered the beneficiary a choice between a check for the full amount and a series of payments. That series is called a settlement option, and the question we hear is whether it is taxable. The short answer: the death benefit is not, the interest the insurer adds to it is. Below: what the IRS taxes, the numbers on a $250,000 benefit, and how the insurer's plan compares with taking the lump sum and buying an annuity on the open market.
What "Life Insurance Annuity" Usually Means
Life insurance policies have long included settlement options: instead of a lump sum, the beneficiary (or, on some policies, the owner while still living) can leave the proceeds with the insurer and take them as income. Western & Southern, one of the eight carriers in our rate tables, lists the standard menu: lump sum, interest only, interest accumulation, fixed period, lifetime income, and lifetime income with a period certain. The same page tells beneficiaries that interest paid under any of them is taxable as regular income when received (Western & Southern, updated July 1, 2026).
In plain terms, there are three shapes:
- Interest only. The insurer keeps the principal, pays you the interest, and lets you withdraw the principal later.
- Fixed period or fixed amount. Principal plus interest is paid in equal installments over a set number of years, then it stops.
- Life income. The insurer turns the death benefit into a payment for the rest of your life, with or without a guarantee period. This is the insurer selling you an immediate annuity, with the death benefit as the premium.
That last point is the whole comparison. A life income settlement option and a single premium immediate annuity are the same product; the settlement option comes at one insurer's price, while the lump sum can go to any carrier that pays more. The other meaning of "life insurance annuity" is an annuity you buy yourself from a life insurance company. As the worked example shows, both routes end up taxed in almost the same way.
How the IRS Taxes It
Three parts of the tax code do the work, and none of them is complicated.
The death benefit is excluded from income. Section 101(a)(1) says gross income does not include amounts received under a life insurance contract, "whether in a single sum or otherwise," if they are paid by reason of the death of the insured (26 U.S.C. §101). IRS Publication 525 puts it in plain English: proceeds paid because of the insured person's death generally are not taxable unless the policy was turned over to you for a price (Pub 525, 2025 edition).
Interest on money left with the insurer is income. Section 101(c): if the excluded amount is held under an agreement to pay interest on it, "the interest payments shall be included in gross income." The IRS consumer FAQ says the same: the proceeds are not includable in gross income, but any interest you receive is taxable and is reported as interest (IRS FAQ, reviewed August 2026).
Installments are split into an excluded part and a taxable part. Section 101(d) prorates the "amount held by an insurer" (the lump sum you could have taken at death) over the payment period. The prorated slice of each check is excluded; anything above it is income. Pub 525's own Example 25: a $75,000 policy paid as 120 monthly installments of $1,000. The excluded part is $625 a month ($75,000 ÷ 120). The other $375 a month is interest income.
For a life income option, you divide by your life expectancy on the insurer's mortality table instead of a fixed number of payments. Treasury Regulation 1.101-4 spells this out and adds a point in favor of the long-lived: the excluded amount stays excluded even after you outlive the table (26 CFR §1.101-4). A refund or period certain guarantee reduces the amount held by the insurer by the guarantee's actuarial value before you divide, per Pub 525, which trims the excluded part a little.
Two footnotes. Pub 525's $1,000 a year interest exclusion for surviving spouses applies only where the spouse died before October 23, 1986, so not to a claim today. On state tax, most states with an income tax follow the federal split (interest taxed, principal not), but we have not checked all 50; check with your state revenue department, or start with our state annuity pages.
What the insurer sends you
Interest only payments usually come with a Form 1099-INT; the IRS instructions for that form list "interest on delayed death benefits paid by a life insurance company" as reportable interest (1099-INT instructions). Installment and life income payments are usually reported on a Form 1099-R showing the gross amount and the taxable part (Guardian describes both forms this way to its own policyholders: Guardian, January 2026). Ask which form you will receive and whether it shows the excluded portion; practice varies by carrier.
Lump Sum vs. Monthly Payments: What the Numbers Look Like
The tax rule is settled. The real question is whether the insurer's settlement option pays enough to beat what the lump sum could earn or buy elsewhere.
Start with what the policy guarantees. Settlement option rates are written into the policy at issue, sometimes decades before the claim. Policy forms filed with the SEC show the usual shape: one variable universal life prospectus states that "a guaranteed interest rate of 3.0% per year applies to all settlement options" and that the company "may pay additional interest in Our sole discretion" (American Family VUL prospectus, filed December 2008). A 1982 Pruco Life contract form reads the same way: interest "at an effective rate of at least 3% a year" on the interest option, 3.5% on the installment options, and "We may credit more interest" (Pruco Life form VL-83). Your policy's guarantee is printed in its settlement options section and may be higher or lower. Either way it is a floor; what the insurer will credit today is a number you have to ask for.
Here is the arithmetic on a $250,000 death benefit if the insurer credits 3%:
- Interest only: $625 a month ($7,500 a year), all of it taxable, principal untouched and withdrawable.
- 20-year fixed period: about $1,386 a month. Of that, $1,042 is excluded ($250,000 ÷ 240) and roughly $345 is taxable interest. Payments stop after 240 checks.
- Life income: depends entirely on the insurer's table for your age and sex. Get the figure in writing.
Now the open market. In our rate tables as of , the best of the eight carriers we publish, all rated A or better by AM Best, pays this on a $250,000 premium at 65 (scaled in proportion from our $100,000 figures), single life with a 5-year period certain (the couple: joint life, 100% to the survivor, both 65):
| Who | Best carrier, per month | Per year | Lowest of the 8, per month |
|---|---|---|---|
| Woman, 65 | $1,645 | $19,740 | $1,353 |
| Man, 65 | $1,733 | $20,790 | $1,433 |
| Couple, both 65, 100% to survivor | $1,520 | $18,240 | $1,230 |
Source: LifeAnnuities.us quote surveys run for real clients. The figures start from quotes our agent runs for real clients, not advertised rates or illustrations. For the base tables we received 54 survey runs covering 30 client scenarios, prepared July 14 to September 14, 2026, and used 52 of them for pricing (2 runs used annual payments and were left out of pricing). 17 carriers were quoted. On we checked the tables against 7 new survey runs (4 client scenarios, prepared September 18 to 29, 2026). 11 runs were received and 4 were not used (4 runs were for a 41-year-old, well below our table ages; two of them were at $5,000,000). We repriced 1 of the 8 carriers we publish (Athene, up about 1.8%) and held the other 7 at their earlier figures. A repriced carrier has its whole table moved by its own measured change on quotes for the same age and sex. New York Life: readings were mixed, so we held its figures until the next round. Two direct comparisons with mid-September quotes came in 0.7% and 1.6% higher once premium size is allowed for. A third, measured through August, came in 0.6% lower. How each figure is built. Men: 60, 65 and 80 read at surveyed ages; 55, 70 and 75 interpolated between surveyed ages. Women: all ages derived by ratio. Joint: 55, 60, 75 and 80 derived by ratio; 65 and 70 calibrated to a direct same-age joint quote. None of the figures in our tables is a direct quote from the latest survey round. They are built from earlier rounds (read at surveyed ages, interpolated or derived from carrier ratios) and checked carrier by carrier against the latest one. Joint figures at ages 65 and 70 are calibrated to a direct joint quote (same-age joint quote, both spouses 66, 100% to the survivor, 5-year period certain, prepared September 18, 2026). That corrects an estimate. It is not a market move. Basis: single life or joint (100% to survivor), 5-year period certain, income starting next month, per $100,000. Full method and known limits. Free to cite with attribution to LifeAnnuities.us.
The gap between the best and lowest carrier on the same contract runs $290 to $300 a month. The insurer that paid the claim is one company; it may be the best price or the lowest, and nothing in the settlement paperwork tells you which. Other ages: the age 65 rate page, the female and joint pages, and the $250,000 payout guide.
In fairness to the settlement option: it is simpler. No new application, no suitability paperwork, no agent, and a company you already have a claim file with. If its life income figure lands within a few dollars of the best market quote, taking it is a reasonable choice. The point is to know the figure before you sign.
A Worked Example With the Taxable Slice
Take a widow, 65, with a $250,000 death benefit. She has three routes.
Route 1: lump sum. $250,000, none of it income under §101(a). She can invest it, spend it, or buy an annuity later.
Route 2: the insurer's life income option. Suppose the insurer's table gives a 65-year-old woman a 20-year life expectancy and it offers $1,400 a month ($16,800 a year). Under §101(d) the excluded part is $250,000 ÷ 20, or $12,500 a year. The remaining $4,300 is interest income. If she lives past 85, the $12,500 exclusion continues under Reg. 1.101-4.
Route 3: lump sum, then a SPIA from the best carrier. She takes the $250,000 tax-free and buys a single life annuity with a 5-year period certain. The best figure in our October 2026 rate tables pays $1,645 a month, $19,740 a year. Now §72 governs: the excluded part of each payment "bears the same ratio to such amount as the investment in the contract bears to the expected return under the contract" (26 U.S.C. §72(b)). Investment, $250,000. Expected return, $19,740 × 20.0, the IRS Table V multiple at 65 (Pub 939, Rev. December 2025). That gives an exclusion ratio of about 63.3%: $12,500 a year excluded, $7,240 taxable. (The 5-year guarantee trims the investment figure slightly under Pub 939's refund-feature adjustment.) Once the exclusions total $250,000, around age 85, payments become fully taxable under §72(b)(2).
The excluded amount is $12,500 on both Route 2 and Route 3. The tax code is not choosing between them. The SPIA pays $2,940 a year more, taxed at her ordinary rate, and she keeps what is left. A higher payment with the same exclusion is simply more money. More on the exclusion ratio in how annuities are taxed; more on the 5-year guarantee in the payout options guide.
Six Questions to Ask the Insurer Before Choosing
- What is the exact monthly payment under each option, in writing, and is it guaranteed for life or only for a set number of years?
- What interest rate are you crediting today, what is the guaranteed minimum in the policy, and how often can the current rate change?
- If I die early, what happens to the balance, who receives it, and can I name that person myself?
- Once I choose, can I change my mind or withdraw principal, and on what terms? Western & Southern's page says a lifetime income election typically cannot be changed or drawn against once it is set up, and that is the norm.
- Which tax form will you send each year, 1099-INT or 1099-R, and will it show the excluded portion?
- Where is the money sitting right now, is it earning interest while I decide, and is there a deadline on the election?
Then ask the open market the same question: what would $250,000 buy from a carrier that has to compete for it? Our guide to comparing SPIA quotes shows how to put two figures on the same basis (the same age, guarantee period, and start date). Choosing for a couple? The joint and survivor guide explains which survivor percentage to ask for.
What to Do Next
Do not sign a settlement election under time pressure. The lump sum is tax-free whenever you take it, and waiting a few weeks to compare figures changes nothing about that. Get the insurer's numbers in writing, including the life income option and the rate it is crediting now. Then ask Phil to run a multi-carrier quote on the same basis. The rate tables on this site show 8 carriers; the surveys behind them quoted 17. He will tell you plainly if the insurer's offer is already competitive. Start on the quote page, or try the calculator for a rough number first.
