Life Insurance vs. Annuity: What's the Difference?

An Overview of Life Insurance vs. Annuities

Permanent life insurance policies and annuity contracts appear to have polar opposite aims at first appearance. While life insurance aims to offer a lump-sum financial payoff to a person's family when he or she dies, annuities serve as safety nets by providing individuals with lifetime guaranteed income streams. Both are frequently advertised as tax-advantaged alternatives to typical stock and bond investing. They all have substantial operating costs, which might reduce investment returns.

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TAKEAWAYS IMPORTANT

• Individuals can invest tax-deferred through both life insurance and annuities.
• After a person dies, life insurance pays out to their loved ones.
• Annuities collect payments up front and then provide policyholders with a lifetime income stream until they die.
• Non-qualified annuities are funded with after-tax money, while qualified annuities are funded with pre-tax money.
• Fees for both life insurance and annuities are often high.

Life Insurance

Life insurance financially safeguards your dependents in the event of your passing. There are several types of policies:

Term Life Is Simple

A term life insurance policy merely pays a death benefit to a person's loved ones.

Permanent Existence

These plans, sometimes known as cash-value policies, include a savings component. As a result, premiums are typically significantly higher than those associated with comparable term insurance.

Throughout Your Life

Life insurance companies credit policyholders' cash accounts with whole life policies depending on the performance of relatively conservative investment portfolios.

Life Expectancy Variable

These life insurance policies boost the growth potential of a policy by allowing policyholders to invest in a basket of stock, bond, and money market funds. However, if the underlying investments underperform, variable life insurance pose an elevated risk.

The money in the cash/investment account of a policy increases tax-free. Consumers do not pay taxes on investment profits until the money are actually withdrawn, unlike traditional investing or savings accounts. These policies also provide you more spending options. If your cash balance is sufficient, you can take out tax-free loans to cover unforeseen expenses. As long as you repay the borrowed amount plus any accrued interest, the full death benefit will be preserved.

Special Life Insurance Considerations

It's crucial to understand that using life insurance as an investing plan includes disadvantages, such as hefty fees. The sales representative's commission accounts for almost half of a policyholder's premiums. As a result, it takes some time for a policy's savings component to gain traction.

In addition to the initial expenditures, policyholders must pay annual administration and management fees, which can offset the tax-deferred growth benefits of the funds. Furthermore, fees are frequently opaque, making it impossible to compare companies. Unfortunately, many consumers let their insurance lapse after only a few years because they can't keep up with the strict payment schedules.

Many fee-based financial advisors advise investors to buy lower-cost term insurance policies and then put the money saved on permanent life insurance premiums into tax-advantaged retirement accounts like 401(k)s or IRAs. This strategy allows policyholders to pay lower investment fees while still benefiting from tax-deferred gains.

Cash value plans may be appropriate for individuals who have already maxed out their contributions to these tax-advantaged retirement accounts, especially if they choose low-fee providers and have the opportunity to allow their cash holdings grow. Furthermore, high-net-worth individuals may place cash value policies in irrevocable life insurance trusts to save federal inheritance taxes, which can be as high as 40% for beneficiaries.

Annuities

Many people are concerned that they will not have enough money in their retirement years to live comfortably. Annuities were created to help with these worries. An annuity is a contract with an insurance in which individuals agree to pay the firm a set amount of money, either in one lump sum or in installments, in exchange for a series of payments at a later period. These payments are usually made for a set period of time, such as ten years. Other annuities provide lifetime payments. In either situation, policyholders are assured of a financial safety net.

Over the years, the number of annuity products has expanded. Fixed contracts, which credit your account at a guaranteed rate, and variable contracts, whose returns are tied to a basket of stock and bond funds, are both examples of this. There are also indexed annuities, which track the performance of a certain benchmark, such as the S&P 500 Index.

Annuities: Special Considerations

Unfortunately, annuity products, like permanent life insurance policies, come with high upfront commission fees that might eat into long-term earnings. They also have significant surrender costs, which are effectively fines that investors must pay if they remove money from an annuity contract early or cancel it entirely. As a result, an annuity's funds may be locked up for up to a decade. It's not uncommon for a policyholder to lose money on distributions made in the early years of the contract.

The way taxes are handled is also a source of worry. Although earnings increase tax-deferred, any investment gains would be subject to ordinary capital gains taxes if a policyholder withdraws assets before reaching the age of 59 1/2.

For all of these reasons, annuities are the best option for families with a history of longevity. A lifetime income stream is critical for people who are projected to live to be 90, especially if their 401(k) withdrawals and Social Security payments fall short.

Variable annuities are only a good idea for younger investors who have already maxed out their 401(k) and IRA contributions and are looking for tax shelters.

Non-Qualified Annuities vs. Qualified Annuities

Non-qualified annuities include the aforementioned annuities. Qualified annuity contracts are those held in Individual Retirement Accounts (IRAs) or other tax-advantaged retirement plans, such as 401(k)s. Non-qualified annuities are funded with after-tax earnings, while qualified annuities are funded with pre-tax dollars.

The same early withdrawal penalty and required minimum distribution (RMD) rules apply to qualifying annuity contracts as they do to other investments in qualified retirement plans.

Former President Donald Trump signed the CARES (Coronavirus Aid, Relief, and Economic Security) Act, a $2 trillion coronavirus emergency stimulus program, into law on March 27, 2020. If the withdrawals are attributable to the financial impact of the coronavirus, the CARES Act waives the 10% tax penalty for early withdrawals from retirement assets, including qualifying annuities. The waiver goes into effect on January 1, 2020. In addition, you will not be required to take an RMD from your retirement account in 2020.