Annuities Vs. Life Insurance

byAnnuityRatesHQ Staff

Wed Apr 17 2024

Staff @ AnnuityratesHQ
Annuities Vs. Life Insurance.webp

Annuities Vs. Life Insurance

If you’ve set off to determine the most reliable ways to fund your retirement then you’ve likely come across both annuities and life insurance. Many retirees crave these two products, as they can provide consistent income to both the owner and their loved ones. 

If you don’t feel like reading, here’s a quick TLDR on which is better: Annuities Vs. Life Insurance. But, I’d definitely recommend reading the full article.

Annuities Vs. Life Insurance: Which is best for you?

If you’re looking for a financial product that offers you consistent income during your retirement then you’ll probably want to go with an annuity. But, if you’re more interested in a product that can help protect your loved ones financially then you’ll want to go with a life insurance policy.

You can amend an annuity so that it protects your family in the event of your death. Similarly, you can use a life insurance policy as an investment tool. There’s a lot of overlap between these two products. So, to get a better understanding of which product is better for you, let’s break down annuities vs. life insurance.

What is an Annuity?

The Internal Revenue Service defines an annuity as a financial product that requires regular payments for more than one full year to the person entitled to receive the payments (annuitant). In non-IRS speak, an annuity is a contract between you and a financial company. You give them money (that they invest on your behalf) and they agree to pay you back with interest when the time comes. The process of buying an annuity typically looks something like this:

  1. You buy an annuity: There are many different types of annuities. So, you’ll want to research the type that’s best for you (more on that in the next section). Once you’ve found the right product, you sign a contract.

  2. You make payments: In most cases, you’ll make small payments to the financial institution for a period of time. But, you can also choose to make a one-time lump sum payment.

  3. You receive payments: At a predetermined time, you stop making payments and start receiving payments in return.

  4. Pass your benefits on to a loved one: In the event of your death, you can typically arrange for your payments to go to someone else (called a beneficiary).

With this in mind, you can also choose your annuity based on when you want to start receiving payments. If you want to start receiving payments immediately after making a payment then you should choose an immediate annuity. But, if you want to receive your payments at some point in the future (such as after you retire) then you should choose a deferred annuity.

With that in mind, the IRS recognizes six types of annuities. In general, annuity companies structure annuities based on how and when you want to make payments and receive benefits.

6 Types of Annuities:

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  1. Fixed annuity: The annuitant (which is usually you) receives a fixed payment at regular intervals for a predetermined period of time. This can help provide a stable income during your retirement.
  2. Variable annuity: The annuitant receives payments that vary in amount for a definite period of time. With this type of annuity, the amount you receive depends on things like profits earned by the pension or annuity funds or by cost-of-living indexes. You take on slightly more risk, as you could either earn a higher or lower return.
  3. Single life annuity: The annuitant receives a fixed amount for the rest of their life, with the contract ending when they pass on.
  4. Joint and survivor annuities: The annuitant receives a fixed amount for the rest of their life, with payments going to a second annuitant after the first annuitant passes on. 
  5. Qualified employee annuities: An annuity that you might receive from your employer as a work benefit. 
  6. Tax-sheltered annuities: a special annuity plan or contract purchased for an employee of a public school or tax-exempt organization.

Benefits of Annuities

  1. Fixed returns: One of the most common benefits of annuities is that they provide fixed returns. This means that you can expect a set payment for the length of your contract. This type of stability can be immensely valuable when planning your retirement.

  2. Timeline flexibility: Many investments have an element of “timing risk.” For example, if the stock market crashes right after you retire then you’re out of luck. Annuities can help remove this risk by creating a set schedule for payments. You can also buy annuities that are guaranteed to provide income for the rest of your life – eliminating the risk of running out of cash during retirement.

  3. Flexibility: Many annuities offer the ability to include add-ons, called riders. This gives you a level of customization, as you can take a pre-packaged annuity and tweak it to your preferences.

Cons of Annuities

  1. Lower returns: Investors do not buy annuities for their high returns. In most cases, you can get a higher return by buying stocks, real estate, or other assets. But, the tradeoff is that you are guaranteed a fixed return (which is not the case with other assets).

  2. High costs: Annuities are known for being expensive, which can erode your returns.

  3. Complexity: Similar to insurance contracts, annuities can be very complex. This makes it difficult to know what exactly you’re signing up for and what rate of return you’re generating.

  4. Risk of bankruptcy: Your returns are guaranteed by the company that issues the contract. However, there is still the possibility that the company you’re working with will go out of business by the time you’re ready to retire (granted, this risk is inherent for any company that you’re investing with).

What is Life Insurance?

Life insurance is a contract between you and an insurance company. In exchange for a month payment, the insurance company will pay a death benefit to your beneficiaries when you pass away. In general, there are two types of life insurance policies:

  1. Term Life: Covers you for a fixed amount of time that’s determined at the time of purchase. Usually, term life policies will cover you for between ten and forty years. If you pass away within the time frame then your policy will pay benefits to your beneficiaries. But, if you do not pass then no one receives payment.

  2. Permanent Life: Covers you until the end of your life. When you pay into a premium life insurance policy, a portion of your premium is added to the cash value (which can generate interest). This cash can grow at either a fixed rate or a variable rate, depending on the policy. You can even make withdrawals from the cash portion of your policy, if necessary.

Since you can build up a cash balance that generates interest, many people consider permanent life insurance to be preferable to term life. However, these added benefits mean you’ll have to pay a higher monthly premium. 

Nerdwallet estimates that the average term life insurance policy costs just a few hundred dollars or less per year, while permanent life insurance can cost several thousand.

Why Would I Want Life Insurance?

You can usually expect life insurance policies to protect your beneficiaries in the event of your natural death, accidental death, suicide, homicide, illness, or war/terrorism event. If you have people who depend on you for income then a life insurance policy can help protect them in case something happens to you.

The three most common scenarios where you might want life insurance are:

  1. Others rely on you for income: If you’re the main breadwinner in your family then you might consider taking out a life insurance policy. This way, your family will still have cash coming in in case anything happens to you.

  2. You want to help others pay large debts if you pass away: Life insurance policies can also be used to cover large expenses like a child’s tuition or outstanding mortgage. Even if you aren’t the main breadwinner, you might still want a life insurance policy to help your family pay for these expenses.

  3. You want to cover your funeral expenses: Even if you aren’t the main breadwinner, taking out a life insurance policy can ensure that your funeral expenses are paid for and do not fall on someone else.

Most people use life insurance as a safety net to protect loved ones financially. But, if you’re comparing annuities to life insurance, then there’s a good chance that you plan on using your life insurance policy as an investment. If this is the case, be sure to double-check that your policy has a cash value component, as not all do.

Life Insurance as an Investment

Life insurance can sometimes have a dual purpose: protecting your loved ones while also building up a cash value. You can then leverage this cash value to your advantage. According to MarketWatch, there are three main benefits to using life insurance as an investment:

  1. Tax Advantages: The cash value of your policy is tax deferred, similar to a retirement plan. This means that you won’t have to pay taxes on earnings until you withdraw them. Death benefits are also usually income-tax-free to beneficiaries.

  2. Potential Income Streams: A life insurance policy can turn into an income stream during retirement, almost like having a mini pension plan or social security. This stability protects you from the ups and downs of the stock market.

  3. Asset Protection: Permanent life insurance policies also tend to be protected from creditors. This allows you to safeguard your hard-earned money and assets from potential lawsuits and creditors – especially if you plan on passing your money on to other people.

Cons of Life Insurance as an Investment

Although life insurance can be treated as an investment, this is not its main purpose. Here are more cons associated with life insurance as an investment:

  1. Minimal Returns: Life insurance provides a lot of certainty. But, the tradeoff for this certainty is a low return when compared to other assets. 

  2. Opportunity cost: Investing in a life insurance policy might leave minimal cash to invest in other assets. So, if the stock market rallies 20% in a year then you having cash tied up in a life insurance policy could leave you frustrated. 

  3. Limited Flexibility: Permanent life insurance policies can have limited flexibility when it comes to premium payments or death benefits. This isn’t ideal for investors who have specific needs when it comes to retirement or estate planning.

Should You Buy Life Insurance or an Annuity?

annuities and life insurance.

Ultimately, the decision to buy life insurance or an annuity is a personal one. I always recommend speaking with a financial provider before making a decision – especially since trying to back out of an annuity or life insurance contract will likely come with hefty fees. 

However, I’d recommend exploring annuities further if you are interested in funding your retirement first and protecting loved ones second. But, I’d recommend exploring life insurance policies further if you’re interested in protecting loved ones first and funding your retirement second.

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