Center for a Secure Retirement
Annuity vs. Life Insurance: What's Right for You?

Annuity vs. Life Insurance: What's Right for You?

Life insurance and annuities can be key pillars of your overall financial planning strategy. Insurance companies sell both products, and they're similar in many ways, but there are also some key differences.

If you're trying to settle an annuity vs. life insurance debate, this article will walk through these details so that you can be better prepared to make the right choice for your financial needs.

The Differing Purposes of Annuities vs. Life Insurance

First, let's define what we're talking about:

  • Life insurance is a contract in which an insurance company agrees to make a financial payment to your designated beneficiary or beneficiaries following your death in exchange for money, which you pay in monthly premiums.
  • An annuity is a contract between you and the seller (typically an insurance company) in which you pay for a guaranteed series of payments. An agreement in which those payments begin right away is called an immediate annuity. A contract that calls for delayed payouts is a deferred annuity. Some annuities come with a death benefit, too.

In the most basic sense, the annuity vs. life insurance comparison comes down to this: Life insurance pays money to someone else after you die; an annuity pays you money while you're still alive.

The main purpose of a life insurance policy is to provide financial protection after your death to beneficiaries who depend on your income. Proceeds from a life insurance policy can also help pay your funeral expenses and any debts you leave behind.

An annuity helps protect you from outliving your assets by issuing regular payments. You can use an annuity to fund your retirement or to manage your money during retirement so that you don't run out.

Saving for Retirement

Annuities and some life insurance policies let you save or invest the funds in your account and increase its value over time.

Permanent life insurance — which includes whole, universal, variable and variable universal life policies — provides a cash value on top of a death benefit. Its value can grow over time in a savings or an investment account. Term life insurance policies don't include this cash-building feature.

The three types of annuities — fixed, variable and indexed — all work as savings and investment vehicles. With a fixed annuity, the insurance company sets the minimum interest rates you'll earn and can only change those rates once a year. A fixed annuity also comes with a guarantee that your principal — the original amount you put in — will be preserved.

With a variable annuity, your money is invested in stocks, bonds and money market funds. The value of your account depends on how these investments perform and could change from day to day.

With an indexed annuity, you earn an interest rate tied to the performance of a specific market index. The largest of these are the S&P 500, the Nasdaq composite and the Dow Jones Industrial Average, but there are thousands of market indices.

Annuities and insurance accounts invested in the markets have higher earning potential, but there's also more risk than those that pay set interest rates.

Tax Implications

Annuities and life insurance policies with value-building components are tax-deferred financial products, which means you don't owe taxes on any interest or investment earnings your account gains until you withdraw the money. When you do, the funds are taxed as ordinary income. If you make a withdrawal from either before age 59 1/2, you might incur a 10% federal tax penalty.

Life insurance beneficiaries usually don't pay taxes on the death benefits they receive, and they don't need to report the income to the IRS. However, if they receive the benefits in installments instead of as one lump sum, they'll pay taxes on any interest earned on the unpaid portion of the benefits.

Unlike life insurance benefit payouts, proceeds from annuity death benefits are always subject to income taxes.

Potential Fees

The fees associated with life insurance policies and annuities can add to their total cost to you and affect their earnings as tax-deferred financial products. These fees reduce the initial value of your account and could increase the amount of time it takes to build up earnings.

When you buy an annuity or a life insurance policy, a portion of your payment goes toward the sales commission. Annuities and life insurance policies might also carry administrative and investment management fees. And you could face a surrender charge if you cancel a life insurance policy or withdraw money from an annuity before a contractually specified time.

The amount of these fees will vary depending on the insurer and the type of annuity or life insurance policy you buy, so review any documentation and consult your financial advisor before making any decisions.

Annuity vs. Life Insurance: Which to Buy and When

Whether life insurance, an annuity or both fit into your long-term financial planning strategy depends on what you and your family need.

Life insurance might be a smart choice if:

  • You have family members or other dependents, and you want to continue providing them financial security after your death.
  • You want funds to pay for your final expenses.
  • You want to create a forced savings plan by having some of your premium payments earn interest or investment returns.

An annuity might be a smart choice if:

  • You want the guarantee of a minimum income during your retirement years.
  • You've maxed out your annual contributions to other tax-deferred financial products for retirement savings, such as a 401(k) or an individual retirement account (IRA).

Key Steps Before You Purchase

Making a wise consumer choice when purchasing a life insurance policy or an annuity begins with a few key steps.

  1. Determine your financial goals.
  2. Review the options available.
  3. Decide whether a low-risk or high-reward return is your top financial priority.
  4. Understand the tax implications.
  5. Determine how fees will affect your total cost and benefits.
  6. Seek additional information and guidance from an insurance agent or financial advisor.

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