The Key Differences Between Life Insurance and Annuities

Annuities and life insurance are both insurance products. The key difference is that annuities provide you with a guaranteed income while you’re alive. Life insurance provides your family with money once you pass away.

Preparing for retirement can feel like an arduous journey. The two central questions we ask ourselves when planning for our retirement are: Will I have enough money to live comfortably for the rest of my life? And, are my loved ones financially protected when I die?

Annuities are designed for the first question by offering a guaranteed retirement income.

Life insurance was designed for the second. It helps you feel comfortable your family will thrive after you die.

Both life insurance and annuities can be useful. Here are the details about each and how each one can be beneficial.

Annuities and Life Insurance Have Different Purposes

A life insurance policy is designed to provide financial support to the policyholder's beneficiaries in the event of the policyholder's death. It provides a lump-sum payout to beneficiaries. That lump sum can be used to cover expenses related to end-of-life costs, such as funeral expenses. It can also help support the policyholder's loved ones, such as helping with living expenses or paying for children's education.

Life insurance is often especially desirable for the main breadwinners of a family. That way, if the main income earner dies, the family has the financial resources to carry them through.

An annuity contract is an insurance product that works like a private pension. Its purpose is to help you live comfortably while you’re alive. First, you purchase an annuity and pay the premiums into your annuity account. With deferred annuities, those premiums earn interest and grow in value. Later, you can annuitize and begin the payout phase, where your money is paid back to you.

Annuities help give you peace of mind that you’ll continue to have some income after you stop working. They’re especially useful for those who aren’t sure how much money they need for retirement and want to supplement their social security and pension.

Note that there are several different types of annuities, and they differ from each other in various ways. Always make sure you understand how an annuity works before buying it.

Also, note that some annuities come with death benefits. This means that any money left in your annuity account when you die would be passed on to a beneficiary.

Differences in Funding

One difference between annuities and life insurance is how you fund them.

You fund a life insurance policy by paying premiums to the insurer on a regular basis — usually monthly, quarterly, or annually. The cost of life insurance premiums depends on many factors, including the type of life insurance that you purchase, the length of your policy term, the amount of your coverage, your age, your health, and other factors.

It’s a good idea to select a policy with premiums you can afford because if you fail to make a payment, you may void the policy. That can then compromise any future payout to beneficiaries.

You fund an annuity by paying a premium to the insurance company. Note, though, those premiums continue to be your money. They sit in your annuity account and grow. When you annuitize your annuity, they’re paid back to you.

Some annuities also let you choose how to pay for premiums. You pay single-premium annuities with a single lump-sum payment. With flexible premium annuities, you fund your annuity with multiple smaller payments over time. This allows you to build up your investment over time, with the knowledge that they will receive a payout from it in the future.

Different Payment Structures

Annuities and life insurance differ in their payout structures.

With life insurance, you typically can choose between two payout structures: a lump sum payout or installments. With a lump sum payout, beneficiaries receive a single payment all at once.

With installments, the life insurance company pays beneficiaries over time.

For example, imagine you had a $500,000 life insurance policy that you left to your wife. She could opt to receive $50,000 each year for 10 years.

With annuities, there are several payout options to choose from. Here are some of the most common:

• Single-life. Your annuity will continue to pay you an income until the end of your life. If you die before you recover your principal, the company may keep the remainder.
• Life annuity with period certain. You will receive income for the rest of your life, but if you die within the “certain period,” any remaining income goes to a beneficiary.
• Joint and survivor annuity. This option pays an income while either you or another beneficiary (often a spouse) are still alive. Payments end when you both die.
• Lump-sum payment. You can opt to take your entire annuity payment upfront. This defeats the purpose of lifetime income and would have negative tax implications, but could be useful if you have an emergency.
• Systematic annuity withdrawal. With this withdrawal choice, you opt for custom periodic payments. There’s no limit to the amount you receive each month.
• Early withdrawal. In this option, you take money out of your account before the end of the surrender charge period. You may face surrender charges for this, as well as potential tax penalties from the IRS.

Life Insurance and Annuities have Different Tax Implications

One of the most important benefits of any life insurance policy is that all death benefits paid out to the beneficiary are generally considered tax-free income. This provides the policyholder with the additional comfort of knowing that their beneficiaries will not have to fear that a sizable percentage of their hard-earned benefit will go to taxes while suffering the additional loss of their loved one.

Annuities, on the other hand, offer tax-advantaged growth. Your earnings in an annuity aren’t taxed in the year you earn them. Instead, they’re taxed when you withdraw the earnings. That lets your money compound faster.

How you are taxed depends on the type of funds you buy an annuity with — either qualified or non-qualified funds. You buy a non-qualified annuity with after-tax dollars, meaning that you have already paid taxes on the money. When you receive your payout, you only pay tax on the interest or earnings — not the premiums.

On the other hand, you fund a qualified annuity with pre-tax dollars, meaning that you haven’t paid taxes on the money. When you get your withdrawals, you have to pay taxes on the entire withdrawal amount. You pay ordinary income tax, and the withdrawals count toward your taxable income.

Which Option is Right for You?

So which one is right for you? It depends on your financial circumstances and goals. Here are some important factors to consider.

Current Financial Situation

Annuities are great for people with a stable income and who are looking for a way to save for retirement. Because taking money out of an annuity can result in fees, it’s best to be sure you will not need the money you put in an annuity in the short term.

Life insurance policies are also good for people in stable financial situations. They may also be useful for families where one person is the main breadwinner since they protect your loved ones in the event of an unexpected death.

Goals

The main aim of an annuity is to help you save for retirement and ensure you have a regular income payment even after you finish working. If your goal is to grow your nest egg or create a guaranteed lifetime income, annuities are an appropriate choice.

The main aim of life insurance is to protect your family after your death. Life insurance may be good choice if you are looking to ensure your family has resources after you die.

Age

Your age — and the age of your family — can play a role in your decision, too.

Annuities can be appropriate at any age, depending on your goals. But they’re particularly attractive to people coming up to retirement or who are already in it.

Life insurance is often more appropriate for younger individuals with young families. For example, it may be especially important if you have young children that are financially dependent on your income. It may be less important if your children are grown up and financially independent. It also is not very useful if you don’t have many family members or dependents.

Health

Your health can factor in your decision, too.

For example, many life insurance policies require you to undergo a medical exam before you’re approved. Some pre-existing conditions can make it more difficult to get a life insurance policy. Even if you are eligible, your health may impact the premiums and make it prohibitively expensive, or coverage may be significantly limited.

Health is less of a factor for annuities. You can buy most annuities with no medical exam. In a more likely scenario, your health may affect the kind of annuity and payout option you choose.

For example, if you are in really good health, you may prefer an annuity with a longer term or lifetime payment options. If your health is not as good, you may prefer annuities with a shorter term, or that lets you take money out more flexibly to pay for medical expenses. You may also opt for a term-certain payout option.

Life Insurance and Annuities are Complementary Financial Products

Life insurance and annuities are like a hammer and a screwdriver. Neither is necessarily better than the other. The more appropriate tool depends on what your goal is — do you have a nail or a screw?

Annuities are designed to benefit you. They help you ensure your retirement is more comfortable and help eliminate the worry that you’ll run out of money. They’re ideal for people coming up to retirement or are in it and those who are looking for a safe way to build up their nest egg.

Life insurance is for your family. You’ll never see any of your life insurance money, but it can help you feel secure knowing that, if you die unexpectedly, your family will be able to cover their costs. It’s ideal for younger people, especially those with financial dependents.

The better choice depends on you and your circumstances. Of course, if you’re not sure, you can never go wrong asking for help from a certified financial advisor. They might even suggest that the answer is to get both — life insurance and annuities can be complementary products.

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