Purchased life annuities explained

A purchased life annuity is an annuity bought with ordinary savings rather than with money held inside a pension. You hand an insurance company a lump sum, and it pays you a regular income, normally for the rest of your life. An annuity is defined in official guidance as "a regular income for life or a set period"¹. What makes a purchased life annuity distinctive is the tax treatment: each payment is treated as two parts, and part of it is a return of your own capital, exempt from income tax under section 717 of the Income Tax (Trading and Other Income) Act 2005².

The contrast is with a pension annuity, which is bought with money saved in a pension. Official guidance states that the only types of pension that can be paid from money purchase arrangements are scheme pensions, lifetime annuities or drawdown pensions³. A purchased life annuity sits outside that framework: it is bought from an insurance company with money that has usually already been taxed, or that was taken as tax-free cash⁴.

Because the purchase money is your own, the tax rules accept that part of every payment is simply your money coming back. That part, the capital element, is not taxed again. Only the remainder, the income element, is taxable. The sections below explain where the lump sum can come from, the income and death benefit options, the tax rules in detail, how these annuities are used to pay for care, and the risks involved.

A purchased life annuity and a pension annuity side by side

Both products do the same basic job: an insurance company takes a lump sum and guarantees an income. The difference is the money used to buy them, and that difference changes the tax treatment, the rules that apply and the timing.

A pension annuity is bought with money saved in a pension scheme. When you reach the point where the pension can be paid, the options include taking a scheme pension, buying an annuity, or drawing an income directly from the fund as a drawdown pension¹⁰. With a stakeholder pension, for example, official guidance explains that "you can use the fund you have built up to buy an annuity. This is a regular income, payable for life, which you can buy" from a life insurance company¹¹. The whole of that income is taxed as pension income when it is paid.

A purchased life annuity is bought with money outside a pension: savings, an inheritance, or pension cash you have already taken out. You can use your pension pot to buy an annuity from an insurance company⁴, but once pension money has been taken as cash it becomes ordinary savings, and an annuity bought with it is a purchased life annuity. Because that money has already been taxed (or was paid out tax-free), only the income element of each payment is taxable².

There is a second practical difference. Money inside a pension that is in drawdown remains invested and can keep growing or fall in value. As independent guidance on annuities and drawdown notes, "after you swap your savings for an annuity, this money is no longer invested and so will no longer have the opportunity to grow"¹². That applies to both kinds of annuity, but it is worth weighing whenever savings that could otherwise be invested are used to buy a guaranteed income.

Where the lump sum comes from: savings, inheritance or pension tax-free cash

A purchased life annuity can be bought with any lump sum of money you hold outside a pension. In practice the money tends to come from three places: savings built up over the years, an inheritance, or the tax-free cash taken from a pension.

Pension tax-free cash is the route most tied to the rules. When you buy an annuity you can take a tax-free lump sum of up to 25% of your pension pot at the same time⁵. Pension Wise confirms the same principle: when you take a lump sum from your pension, 25% is usually paid tax-free¹³. If you are using drawdown, 25% of other lump sums you take later can also be tax-free, as long as the total tax-free amount is not higher than 25% of that pension and the lump sum allowance¹⁴. At the point your pension starts, you may take a tax-free cash lump sum¹⁵, and in general you can usually take out 25% of your total savings as a tax-free cash lump sum when you retire¹⁶.

Once that cash is paid to you, it is yours like any other savings. Used to buy an annuity, it produces income of which only the income element is taxed. The remaining 75% of a pension, by contrast, counts as earnings for Income Tax if taken as cash¹³, which is one reason some people take only the tax-free portion and buy a purchased life annuity with it rather than a pension annuity with the whole pot.

Money from an inheritance or from savings accounts works in exactly the same way: it is money you have already been taxed on or that was never in a pension, so the capital element of each annuity payment comes back to you free of income tax².

Who can buy one

There is no rule that ties a purchased life annuity to pension access ages or to having a pension at all. Because it is bought with savings rather than pension money, the restrictions that govern when pension money can be taken, explained on when can I access my private or workplace pension, do not apply to it. Someone with an inheritance or a large savings balance can buy one at any age an insurer will accept.

What limits a purchase in practice is the insurer's own terms. Annuities are bought from insurance companies⁴, and each insurer sets its own conditions: a minimum purchase amount, a minimum age, and health and residency requirements. These differ from provider to provider, so the terms of a particular plan need to be checked with the insurer before any money is committed. The protections that stand behind pension money, such as the rules on pension scams and authorised transfers, do not stand behind a purchase made with ordinary savings, which is one reason to deal only with a firm authorised by the Financial Conduct Authority.

It is also worth remembering that a purchased life annuity is one option among several for turning savings into income. The alternatives include leaving the money invested, using savings accounts, or buying a pension annuity with pension money. The comparison between income drawdown and an annuity sets out the trade-offs, and free guidance is available before any decision.

Income options: how long it pays and how it is shaped

The core choice is how long the annuity pays. Official guidance defines an annuity as "a regular income for life or a set period"¹, so both lifetime annuities and fixed-term annuities exist in the market. A lifetime annuity pays until you die; a fixed-term annuity pays for an agreed number of years and then stops, sometimes with a maturity payment. The comparison of fixed term and lifetime annuities explains the differences in detail.

The second choice is whose life the annuity covers. A single-life annuity covers only you: single-life annuities "only cover the policyholder and stop paying out when you die"⁷. A joint-life annuity keeps paying after your death: payments "will continue to your named beneficiary, usually at two thirds or half of the original payments"⁸. That protection comes at a cost, as joint-life annuities "are typically more expensive to buy"¹⁷. A joint annuity's payments continue to your beneficiary, but will stop once they die¹⁸.

Other features, such as how often payments are made and whether they rise each year, are set with the insurer when the annuity is bought. The critical point is that everything is fixed at the outset. As independent guidance puts it, "you can't pass on income from an annuity after your death unless you arrange this from the outset, for example, by choosing a joint-life annuity"¹². The same logic applies to the other features: they cannot be added or removed later.

Death benefits: what can carry on after you die

With many types of annuity, payments will stop when you die⁸. A single-life purchased life annuity bought with no protection works that way: the payments stop, and the insurer keeps whatever has not been paid out. For someone who dies soon after buying, that can mean a large part of the lump sum is lost, which is why the death benefit options matter as much as the income.

The options, all chosen at the outset, are:

• Joint-life annuity: payments continue to your named beneficiary, usually at two-thirds or half of the original payments, and stop when that beneficiary dies⁸.
• Capital protected annuity: your beneficiary can inherit a lump sum, minus any annuity payments you already received¹⁸.
• Single-life annuity: payments stop when you die, and nothing further is paid⁷.

Inheritance tax generally does not apply to the income itself. Independent guidance states that "income from annuities will not be subject to inheritance tax"¹⁹, and joint-life annuities, which continue paying income to a chosen beneficiary after your death, will still be exempt from inheritance tax⁷. The legislation behind this treatment is section 21 of the Inheritance Tax Act 1984, which provides that so much of a purchased life annuity as is exempt from income tax under section 717 of ITTOIA 2005 shall not be regarded as part of the transferor's income².

This is a different picture from unspent pension lump sums. If you die after starting to take your pension, your beneficiaries inherit any lump sums you took from the pension and did not spend, and may have to pay inheritance tax on that amount²⁰. Money paid out of a purchased life annuity as income, by contrast, falls under the annuity exemption. The page on what happens to your pension when you die covers the pension side, and annuity death benefits and tax covers the detail.

Tax: only the income element is taxed

The tax treatment is the defining feature of a purchased life annuity. Every payment is split into two elements. The capital element is treated as a return of the lump sum you paid in, and it is exempt from income tax under section 717 of the Income Tax (Trading and Other Income) Act 2005. The income element is the rest of the payment, and only that part is taxable².

The legislation sets this out directly. Section 21(3) of the Inheritance Tax Act 1984 provides that "so much of a purchased life annuity... as is exempt from income tax under section 717 of the Income Tax (Trading and Other Income) Act 2005 shall not be regarded as part of the transferor's income" for the purposes of that section². In other words, the law recognises that a slice of every payment is your own money returning, not new income.

The practical effect is that a purchased life annuity pays more after-tax income than a pension annuity of the same headline size, because part of each payment escapes income tax entirely. How large the exempt slice is depends on the terms of the annuity, and the split is fixed when the contract is set up.

Two related points are worth knowing. First, annuity income is not subject to inheritance tax¹⁹, and joint-life annuities remain exempt⁷. Second, section 21(2) of the Inheritance Tax Act 1984 contains an anti-avoidance rule: a payment of a premium on a life insurance policy is not treated as part of normal expenditure if an annuity was purchased on the same life, unless the annuity purchase and the insurance were not associated operations². Anyone combining a purchased life annuity with life insurance for inheritance tax planning should take advice on that rule. The wider picture is on pensions and inheritance tax.

Immediate needs annuities: using a lump sum to pay for care

A specific version of this product is used to pay for long-term care. The Financial Ombudsman Service, which handles complaints about long-term care insurance, describes how it works: "if the customer needed care straight away and didn't have cover in place, they could pay a lump sum to buy an annuity, which would then be used to make regular payments for their care"⁹. These are often called immediate needs annuities or immediate-care plans.

The structure is the same as any purchased life annuity: a lump sum is handed over, and the insurer pays a regular income, in this case designed to cover care fees, usually for life. Because the payments are sized to the cost of care and often to the person's state of health, the income can be higher than a standard annuity would pay. One provider's version, the Just Care Plan, is covered separately on this site.

Care annuities interact with the benefits system, and this needs checking before anything is bought:

• Income that is paid to you and not spent can count as savings when means-tested benefits are calculated: income such as earnings "only counts as savings if it is not spent by the end of the assessment period after the one it's received in"²².
• Some benefits are unaffected by your own savings: Carer Support Payment "is not means-tested. It does not matter what savings you have"²³, and Carer's Allowance "is not means-tested so your savings and your partner's income aren't relevant"²⁴.
• But payments received can affect other benefits: Carer Support Payment "usually counts in full as income when calculating your entitlement for means-tested benefits"²⁵.
• The notional income rule can also bite: if you already get means-tested benefits, "they could be reduced or stopped if you don't take money out of your pension that you're entitled to take"⁴.

Because a care annuity converts savings into income, and income and unspent savings are both relevant to means-tested benefits, the effect on benefits such as Pension Credit should be checked before purchase. The page on how pensions affect Pension Credit and other benefits explains the rules, and free benefits advice is available from MoneyHelper and Citizens Advice.

Once bought, it cannot be cashed in or changed

The single most important fact about any annuity is that the decision is one-way. As independent guidance puts it plainly: "once you've bought an annuity you can't reverse the process"⁶. There is no option to cash the annuity in, transfer it back to savings, or renegotiate its terms later. The lump sum is gone, and what remains is the income as it was set up.

There was once a plan to change this. The government proposed a secondary market that would have let people sell their annuity income for a cash lump sum, but it was scrapped, and the story of the scrapped plan to sell annuities explains why. Someone buying an annuity today should assume the purchase is permanent.

The FCA's cancellation rules provide only a narrow window, and it has limits. The FCA Handbook's rules on the right to cancel, covering cancellation periods for life and pensions contracts, were last updated on 6 April 2026²⁶. But the rules also state that "a firm need not accept notification of cancellation of a pension annuity contract if the life (or any of the lives) assured under it has died before notice is given"²⁷. Cancellation is not a safety net to rely on, and the irreversible nature of the purchase is the reason for shopping around and taking advice first.

Risks: getting back less than you paid

An annuity is a guarantee, but the guarantee runs one way. The insurer guarantees the income; nothing guarantees that the income will add up to more than the lump sum you paid.

The clearest risk is dying early. Single-life annuities "usually stop payments when the person dies"¹⁷, and they "only cover the policyholder and stop paying out when you die"⁷. Someone who buys a single-life annuity at 70 and dies at 72 may receive back only a fraction of the purchase price, and the balance stays with the insurer. Joint-life and capital protected options reduce this risk but cost more at the outset¹⁷.

The second risk is giving up growth. Once the money is swapped for an annuity, "this money is no longer invested and so will no longer have the opportunity to grow"¹². If investments or savings rates perform well over the years, the annuity income stays fixed where it was set.

The third risk is one the FCA requires firms to spell out in comparable products: where charges or withdrawal conditions apply, "the retail client could receive back less than they paid in"²⁸. The same caution applies to an annuity purchased with savings. Inflation is a related pressure: a level income buys less each year, which is why some annuities are set up to increase annually, at the cost of a lower starting income.

None of these risks makes an annuity a bad choice; they are the price of a guaranteed income that cannot fall or run out while you live. But they are the reasons the decision deserves shopping around⁶ and, in most cases, advice.

Guidance, advice and where to get help

Because a purchased life annuity cannot be undone, the help available before buying matters more than usual. There are three kinds.

Free guidance. Pension Wise provides free guidance on pension options for people over 50, covering what can be done with a pension pot²⁹. It will not recommend a product, but it explains the options, including how tax-free cash works. MoneyHelper provides similar free, impartial help on pensions and benefits.

Independent financial advice. Independent guidance on major financial decisions is to "check out all your options and get independent financial advice before you make any decisions"³⁰. A financial adviser will look at your whole situation before recommending anything: official guidance notes that "a financial adviser should ask about the workplace pension scheme offered by your employer and whether you have been enrolled" before suggesting a personal pension³¹, and the same thoroughness should apply to an annuity purchase. Advice is particularly important where care fees, means-tested benefits or inheritance tax are in play.

Shopping around. An annuity need not be bought from the company you already deal with, and rates and terms differ between insurers⁶. The page on annuity providers and shopping around explains how to compare the market, and annuities explained covers the product itself.

If something goes wrong after purchase, complaints about annuities and care plans can be taken to the Financial Ombudsman Service, which handles complaints about long-term care insurance⁹, and the page on complaining about a pension provider explains the process.