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Key Takeaways
- Life insurance pays beneficiaries a benefit upon your death, while annuities give you income, usually during retirement.
- Life insurance is not taxed, but annuity withdrawals are generally taxed as ordinary income.
- Choose life insurance if you want to give your family financial security, and an annuity if you want income during retirement.
Annuities and life insurance are both offered by insurance companies to give you and your loved ones financial protection in the future, but they serve different purposes. The former gives you income while the latter provides your loved ones with financial security. To choose the best option for your situation, you’ll need to understand how each works, including the types available, how they’re taxed, and the risks involved.
How Life Insurance Works
Life insurance is a financial contract between you and an insurance company. In exchange for premiums, the insurer pays out a lump sum death benefit to your beneficiary(s) when you die. It provides your loved ones with financial protection so they can replace your income and cover their bills and expenses.
Types of Life Insurance
Life insurance comes in many forms. Two of the most common types are term and permanent:
Term life insurance provides coverage for a certain period, such as five, 10, or 20 years. If you die within that period, your beneficiaries get paid the death benefit. It is generally the cheaper option. You have the option to renew your policy if it expires, but your premiums will be higher.
Permanent life insurance covers you for your entire life. These policies give you and your beneficiaries a cash value, a feature not provided with term policies. The cash value is a savings portion that earns interest you can access after a certain period. Premiums are higher than term life. Forms of permanent life include:
- Whole life: Lasts your whole life with guaranteed coverage as long as you pay your premiums
- Universal life: Whole life coverage, but lets you adjust your premiums and death benefit
- Variable life: Provides whole life coverage and allows you to invest the cash value, which gives you a high risk and reward potential
Uses for Life Insurance
Life insurance can be used to help your beneficiaries cover your income after you die, as a way to pay for debts, or as an estate planning tool.
It makes sense to take out life insurance if you want to leave your dependents—such as your spouse, children, or aging relatives—with financial protection after you die. If you’re a homeowner, life insurance can also provide your beneficiaries with a way to cover large debts like a mortgage.
How Annuities Work
An annuity is an agreement between you and an insurance company. You pay the company premiums in exchange for income at a later date, often during retirement. This money grows on a tax-deferred basis until you receive it. It can be paid as a lump sum or in a steady stream as monthly, annual, or lifetime income.
Types of Annuities
Like life insurance, annuities come in different shapes and sizes. Some annuities are based on when you get paid, while others are based on how your money grows.
| Annuity Types: When You Get Paid | ||
|---|---|---|
| Immediate Annuity | Deferred Annuity | |
| How It’s Funded | Lump sum | Lump sum or multiple payments |
| When Payments Begin | Typically within 12 months | Later date, usually during retirement |
| How It Grows | No accumulation period | Grows tax-deferred |
| Best Suited For | People who need income now | People who want growth and income later |
| Annuity Types: By Growth | |||
|---|---|---|---|
| Fixed Annuity | Variable Annuity | Indexed Annuity | |
| How It Grows | Guaranteed, set interest rate | Investments are held in annuity | Tied to market index |
| Risk Level and Returns | Low risk, guaranteed returns | High risk, potential for high rewards and big losses | Medium risk with potential for moderate returns |
| Income | Fixed, periodic payments | Rise and fall with investment performance | Minimum guarantee with some upside potential |
| Best Suited For | Safety-conscious people who want some growth | Investors who can handle risk | Balanced investors who want some protection |
Uses for Annuities
People often buy annuities to provide them with a guaranteed source of income, especially during retirement. It gives them a way to complement other income, including Social Security, after they leave the workforce.
Annuities also give investors a way to grow their money on a tax-deferred basis if they choose a deferred annuity. This means the money within the annuity grows without incurring taxes until you start receiving your income.
Fast Fact
Some consumers end up choosing both life insurance and annuities because they want the financial security for their families and the extra income for themselves during retirement.
Key Differences in Tax Treatment
The Internal Revenue Service (IRS) treats life insurance policies and annuities differently. With life insurance, your premiums and death benefit are tax-free. If there is a cash value associated with your policy, it grows on a tax-deferred basis. But withdrawals or loans may be taxable if they exceed the total of your premium payments.
Even though annuities are used for retirement planning, the money you contribute to them isn’t tax-deductible. But the money inside them grows tax-deferred, and you won’t pay taxes until you start receiving withdrawals. The income you receive from an annuity is taxed as ordinary income.
Risk and Investment Considerations
There is generally very little risk with life insurance. You could outlive your policy if you purchase term life insurance, unless you renew it. Another risk is the cost of high premiums. If you can’t keep up with high premiums, you run the risk of policy lapse.
The growth of the cash value depends entirely on the type of life insurance you have. For instance, variable life insurance is typically invested in different assets, while indexed annuities are tied to market indexes like the S&P 500 or the Dow Jones Industrial Average (DJIA).
Annuities aren’t liquid assets, so you won’t get cash if you need it immediately. They come with high costs and fees, which can eat away at your returns. Annuities tied to the market are exposed to market risk, which can impact your income stream. They’re also complex and can be hard to understand.
Variable and indexed annuities allow you to take advantage of the market. Variable annuities invest your money in assets like stocks, bonds, and mutual funds, among others, giving you the potential for high rewards but also big losses. Indexed annuities are tied to market indexes. This means the performance is linked to the performance of the benchmark index.
Choosing the Right Product for Your Financial Goals
You’ll need to ask yourself some questions if you want to decide whether life insurance or annuities are right for you. Do you want to protect your loved ones, or are you trying to find another income stream for yourself in the future? Consider your age, income, family, financial situation, and retirement time horizon before deciding.
For instance, if you’re in your 20s or 30s, married, expecting a baby, and just bought your first home, consider purchasing permanent life insurance. This can give your family financial protection in the event of your death.
If you’re older, closer to retirement, and want a guaranteed income stream, consider purchasing an annuity.
The Bottom Line
Annuities and life insurance give you and your beneficiaries financial protection. With life insurance, you pay premiums and your beneficiaries receive a lump sum when you die. Annuities give you income, usually during retirement, in exchange for a lump sum. What works best for you depends on your circumstances. If you’re uncertain which one to choose, consider speaking with a financial professional.
