What are the Differences Between Annuities and Life Insurance?

To understand the differences between life insurance and annuity products, consider the following phrase: “Life insurance protects you from the risk of dying too early. Annuities protect you from the risk of living too long.”

While this is an oversimplification, it clearly defines the role of each insurance product. Life insurance is predominantly used as a tool of protection in case of early death. Annuities are predominantly used as a tool to protect against outliving your assets.

Though both are insurance products issued by life insurance companies, they play very different roles in your financial playbook. In this article, we explain the differences between annuities and life insurance. We cover the different life insurance products and discuss the most common annuity products. Let’s get started.

Life Insurance Basics

As we mentioned, the primary role of life insurance is to protect your loved ones in the event of your early passing but life insurance can also be used as a long-term tool for tax and estate planning. Life insurance plans provide income for your dependents if you die sooner than expected. And some life insurance policies do offer cash value and income-earning options, as well as other living benefits (like a critical care coverage option).

But the main function of life insurance is to provide money for your dependents after your death. Life insurance financially safeguards your dependents in the event of your passing. The two basic types of policies are term life insurance and permanent, or whole, life insurance.

Term Life Insurance

A term life policy simply pays out a death benefit to your loved ones if you die during a specific time period. This period of time is known as the term, and you get to choose your term life policy term. It is the most affordable type of insurance for several reasons, including the fact that it does not accumulate cash value and will only pay out if you die during the term period.

The vast majority of term life insurance is called “level term,” because the premium you pay stays the same throughout the term. In that same vein, the death benefit your heirs receive (the value of the benefit) remains the same as well. There are a few factors to consider before purchasing your term policy.

First, you have to determine the right amount of coverage for the death benefit. Consider how much you would like to provide your beneficiaries and how long you'd like that coverage to last. As you ponder these choices, also consider your ability to pay the premium.

Make sure that the coverage amount is at least enough to cancel out any current debt, like mortgages, student loans, and car payments. If you can afford to, also add the cost of college for your children onto your death benefit coverage. The death benefit amount is also known as the policy value, and it’s a big factor in determining how much you’ll pay in premiums.

To determine whether you're eligible for coverage and to determine the cost of your plan, the insurer will also consider factors like your:

• Term length
• Age, sex, and health
• Occupation
• Lifestyle and habits, including things like smoking and high-risk hobbies
• Driving history
• Medications
• Family medical history

Since age and health directly impact the cost of life insurance and the risk to the insurer, people in excellent health will pay less than their peers. In contrast, those with health problems will pay more. Smokers typically pay the most for life insurance coverage. If you pass away during the policy term, the insurance company will pay your beneficiaries the death benefit amount.

Generally, life insurance proceeds are not taxed by the IRS, which means your family can count on the full value of your policy. If the term expires before you die and there's no renewability clause, then the policy ends. Therefore, the insurer will not pay a death benefit to your beneficiaries.

Term insurance is an affordable choice, especially for younger buyers looking to protect against an unexpected early death. Though rare, these events can have a major impact on a family. That's why it is a good idea to purchase this life insurance product when you are young and can afford a lot of coverage.

Permanent (Whole) Life

Permanent life insurance policies are also referred to as “cash-value policies” because they have a savings component. And as long as you pay your premiums, they are guaranteed to pay out a death benefit to your chosen beneficiaries. For these and other reasons, permanent life insurance premiums tend to be much higher than term policies. And some permanent life insurance policies come with customizable investment components ( for example, variable life).

There are several situations where a permanent life insurance policy could make sense:

1. Permanent life insurance has a cash value

   All types of life insurance policies provide a death benefit to beneficiaries, most of which are tax-free. However, permanent life insurance policies accumulate a cash value. That's in addition to the death benefit protection. Plus, you can borrow against the cash value as a policy loan.

2. Permanent life insurance provides lifelong coverage

   As long as you’ve paid the premium, the policy will continue. A permanent policy only ends when you die or when you surrender the policy. Some permanent policies mature at a stipulated age, commonly 100 or 121. For example, let’s say you live until 100 and that’s when your policy matures. The life insurance company no longer requires you to pay premiums, and the death benefit will still be distributed when you die. Some policies, however, simply disburse the cash value or pay out the death benefit if you are alive at the maturity date.

3. Premiums never change with whole life

   Whole life insurance is a specific kind of permanent life insurance. With whole life insurance, your premium does not change. The premium amount remains the same, regardless of your age. For example, let’s say you purchase a policy for $50,000 with a $600 annual premium. The policy provides a $50,000 death benefit when you die. It doesn't matter if you die at 40 or 100; the death benefit doesn't change. Neither does the premium. The $600 premium stays the same as long as the policy is in force.

Annuity Basics

Annuities alleviate the concern of outliving your money in retirement. It does this by providing periodic retirement income. Having an income stream in retirement can provide you with peace of mind and improve your quality of life.

Essentially, an annuity is a contract with an insurer where individuals pay the company a certain amount of money, either in a lump sum or over time. These payments entitle them to receive a series of payments in the future.

These payments often last for a specific period—say, 10 years. Or, you can opt for lifetime income (yes, that’s income for the rest of your life). In either case, policyholders know they'll have a guaranteed stream of payments. There are a number of annuity plans, but it’s easiest to think of annuities as being able to accomplish two core functions: accumulating money before retirement and distributing money in retirement.

Annuities that accumulate money before payments begin are known as deferred annuities. There are many types of deferred annuities. The most common are those that offer fixed rates of return (fixed annuities), those with returns linked to an index (fixed index annuities), and those linked to the stock market (variable annuities). Here’s how deferred annuity contracts work and who might benefit from one.

How Does a Deferred Annuity Work?

When you buy a deferred annuity, you give money to an annuity provider. Depending on the options the company offers, you may have several different types of annuities to choose from. You can fund your annuity with a large amount of money at once (single premium) or with smaller amounts over time (flexible premium).

Then, when you’re ready to start receiving income, you can annuitize your contract and receive payments. This accumulation phase stands in contrast to immediate annuities or income annuities. These annuity types provide payouts instantly, but they also generally offer lower rates of return and require you to pay a larger sum upfront.

That’s why immediate annuities are also known as single premium immediate annuities (SPIAs). You can choose to receive deferred annuity payments for a set term, like 20 years, or you can have them last for your entire life. This makes an annuity a great choice for people who want the security of guaranteed income in retirement.

The insurance company will tell you how much you’ll receive each month depending on your account value and the payment option you select. Keep in mind that the longer you set up payments, the lower your payments will generally be. If you select lifetime income, the older you are the higher your payments will be.

Taxes and Withdrawals

Deferred annuities work a lot like individual retirement accounts (IRAs) and 401(k)s. So long as your money is in the deferred annuity, you don’t owe income taxes on your gains. Annuities grow tax-deferred. You will owe taxes when you start collecting payouts. This can help you grow your savings more quickly than if you use a regular brokerage account, where you must pay taxes annually on your gains.

Annuities also tend to have higher crediting rates than savings accounts or Certificates of Deposit (CDs). The tax advantages of annuities do come with a caveat: early withdrawal penalties. If you try to make a lump sum withdrawal or cancel the contract before you turn 59 ½, the IRS could charge a 10% early withdrawal penalty as well as income tax on your gains.

In addition, you could owe the insurance company a surrender charge if you try to take a withdrawal or end the contract during the surrender charge period. Because of these tax and high fee implications, it’s best to use deferred annuities as a long-term investment. Finally, it’s important to note that neither life insurance nor annuities are insured by the FDIC; all guarantees and benefits are backed by the claims-paying ability of the insurance company that issues them.

The Bottom Line

Annuities and life insurance, while both sold by insurance companies, are different financial products and play vastly different roles in your financial plan. Life insurance is generally used to hedge against an early death (term insurance). Or, when it’s purchased as a permanent policy, it’s a great way to protect a business, fund children’s education, or contribute to charity.

Annuities, on the other hand, help you save for, then distribute money in retirement. A Canvas Annuity can be a great way to get started. Our competitive fixed interest rates can quickly help you accumulate money now, then distribute it back to you when you retire. And you can buy 100% online