Annuities vs. Life Insurance: Which Do You Need?
Annuities and life insurance are important to consider as you plan for retirement. Both are tailored to specific needs and can help you build financial protection into your family’s future.
However, many pre-retirees wonder when and how life insurance and annuities should be used, and whether they need to purchase both.
In this article, you’ll discover how annuities and life insurance work, their respective benefits, and the important differences between them.
You’ll also learn what to consider when choosing between different types of life insurance and annuity products, so you can choose the right options to fit your personal situation and goals.
What Is an Annuity?
An annuity is a retirement income option offered by insurance companies. When you purchase an annuity, you contribute a premium (either as a lump sum or in multiple payments), which is then held by the insurance company for a pre-determined length of time.
Over the duration, your contributions gain interest based on the contract’s terms.
Once your annuity has reached its maturity date, you can choose to keep the money in the account and let it grow, withdraw the entire lump sum, or annuitize it to create an income stream. Those payments could last a set number of years or for the rest of your life!
There are three main types of annuities: fixed annuities, indexed annuities, and variable annuities.
Annuities can also vary based on their payment schedule. Immediate annuities begin payouts within 12 months of purchase, whereas deferred annuities may take anywhere from three to 12 years to mature.
Note: All guarantees are subject to the claims-paying ability of the insurer.
Benefits of Annuities
When the aim is to secure a stream of income for your lifetime, annuities offer a multitude of benefits that are hard to overlook:
- Principal Protection: First and foremost, most annuities ensure that your principal is protected, offering peace of mind. This makes annuities a safer choice for your savings than investing in mutual funds, ETFs, and other stock-market opportunities.
- Insurance Company Backing: The strength of the insurance company selling the annuity adds another layer of security.
- Tax-Deferred Growth: Annuities offer the advantage of tax-deferred interest. You won’t be taxed on the interest earned until you make a withdrawal.
- Avoiding Probate: If you’ve purchased a death benefit rider, the account value left in your annuity will directly reach your annuity beneficiaries upon your death, sidestepping the complicated probate process.
- Income Riders: You have the option to add an income rider that ensures a guaranteed lifetime income at a set rate that’s not dependent on your annuity’s account value. Additional riders like COLA riders can structure payments to increase over time, helping fight the value erosion of inflation.
Note: Riders may be subject to eligibility and underwriting requirements, additional premium requirements and/or minimum or maximum coverage amounts. Availability and rider provisions may vary by state.
Note: Any reference to the taxation of annuities in this material is based on Annuitiy.com’s understanding of current tax laws. We do not provide tax or legal advice. Please consult a qualified tax professional regarding your personal situation.
What is Life Insurance?
Like annuities, life insurance is offered by insurance companies. However, the focus of life insurance is primarily on securing your family’s financial well-being in the event of your death.
When you purchase a life insurance policy, you make regular premium payments (similar to car or home insurance). In return, the insurance company commits to paying a death benefit to your beneficiaries if you pass away while the policy is active. This death benefit is typically a lump sum payment.
Life insurance policies can be active for a set term (term life insurance) or last your entire life (permanent life insurance). Term life insurance policyholders are only covered while the policy is active. If they pass away after the policy term ends, their beneficiaries are not provided with a death benefit.
Term life insurance is often used by younger individuals who want to cover a certain time period of their life while saving on premiums. Permanent life insurance is more costly and is usually purchased by higher-income individuals.
Permanent life insurance has a few sub-types as well:
- Whole life insurance: The death benefit insurance pays your beneficiaries is set and does not change over the course of the policy term.
- Universal: Premiums and death benefits can be changed at certain points in the policyholder’s life.
- Variable: This policy type includes a cash value account, which the policyholder can direct towards investments like mutual funds.
Benefits of Life Insurance
For those looking to leave behind financial support for their beneficiaries, life insurance provides a robust set of advantages:
- Income Replacement: The death benefit may replace lost wages, allowing your loved ones to maintain their standard of living.
- Educational Support: You can earmark life insurance proceeds for your children’s or grandchildren’s education.
- Debt Repayment: Proceeds from the policy may pay off debts, including mortgages, thus helping maintain your family’s financial independence.
- Charitable Donations: If you are philanthropic, a portion of the life insurance payout can go to your favorite charity.
- Final Expenses: Life insurance may help cover funeral expenses, alleviating one worry for your family.
- Tax Benefits: The death benefit is income tax-free, providing your beneficiaries with the total amount of the policy.
- Additional Riders: Some policies offer riders for nursing care and other health-related expenses, providing further security.
Key Differences
When comparing annuities vs life insurance, keep in mind that while the two may have overlapping benefits, they also differ in a number of important ways.
- Purpose: Annuities are primarily meant to provide a steady income stream to retirees, while life insurance aims to provide funds to beneficiaries upon a policyholder’s death.
- Purchase requirements: Life insurance policies typically have stringent underwriting requirements, and many life insurance policies require the policyholder to undergo a medical exam before approving the policy. Annuities do not have these kinds of barriers to purchase.
- Premium Funding: Life insurance policies are usually funded by monthly premium payments. Annuities may be funded by a single lump-sum contribution, or split into monthly, quarterly, or even yearly payments based on the contract terms.
- Payout timing: Annuities can be paid out immediately or be deferred, and the funds are typically annuitized into recurring income. Life insurance death benefits are paid after the policyholder’s death and are usually received as a lump sum.
- Tax implications: Typically, life insurance death benefits are not taxable, and do not need to be reported to the IRS. Annuity payments may be taxed in part or whole. If the account was funded with pre-tax dollars, 100% of the payouts are taxable. If the annuity was purchased with post-tax dollars, only the interest earned will be taxed upon distribution.
- Death benefit availability: All life insurance policies provide death benefits to beneficiaries provided the policy was active at the time of the insured’s death. On the other hand, not all annuities include a death benefit provision. In these cases, payments cease completely once the annuitant dies. Annuities that do provide a death benefit have varying provisions based on the contract. Some may provide a pre-determined death benefit while others provide beneficiaries with the remaining account value when the annuitant dies.
When to Buy Life Insurance vs. Annuities
To sum everything up: annuities are best suited for those who want a steady income stream during their retirement years, while life insurance is recommended for individuals who want to leave a financial legacy to their loved ones.
Often, purchasing both annuities and life insurance can provide a stable, secure retirement and the knowledge that your beneficiaries will be taken care of after your death.
But keep in mind, you don’t have to purchase both products at the same time, or even from the same insurance provider! To make the most informed decision about annuities, and see how they align with your goals, consult a licensed annuity agent today.
