Life Insurance vs. Annuities: How they compare
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Life insurance and annuities have many characteristics in common. Both are issued by insurance companies. Each can be a key piece of your long-term financial puzzle. Both can enhance financial confidence and well-being in the years ahead. But that’s pretty much where the similarities end. Life insurance and annuities each play a unique role, each with its key benefits and drawbacks. The important question is: Which is more appropriate for you? Or should you consider purchasing both? Here we'll answer key questions to help you decide, including:
What is life insurance?
The key role of life insurance is to help provide financial protection to your beneficiaries should you pass away. Life insurance is almost always recommended for those with children or other dependents who rely on their income. In the event of your death, beneficiaries will receive a death benefit – usually an income tax-free lump sum payment – which can help cover a range of expenses, from food costs to college tuition.1,2 If you have significant financial obligations, such as a car loan or mortgage, life insurance can help ensure that your survivors won’t be burdened with those obligations.
Certain life insurance policies are also appropriate for those seeking a tax-efficient way to accumulate assets. A permanent cash value life insurance policy accumulates value over time that can be tapped into during your lifetime for expenses such as college tuition, starting a business, or even to help fund retirement.3,4
There are two basic types of life insurance – term and permanent. Which should you get? Consider:
Term life insurance provides coverage for a specified period, usually ranging from 10 to 30 years. It’s a straightforward option that provides a payout to your beneficiaries if you pass away during the term. But once the term is over the coverage ends. Term policies are usually less expensive than permanent policies, which can make a large benefit more affordable.
Permanent life insurance – whole life insurance or universal life insurance – costs more than term but provides coverage that lasts your entire life, so beneficiaries collect a death benefit regardless of what age you pass away. In addition, permanent policies also offer a cash value component: a portion of your premium can grow tax-deferred over time, and you can access the accumulated cash value while still alive.
What is an annuity?
An annuity – which can be referred to as an income annuity, a deferred or savings annuity, or in other ways depending on the specific type – is a financial product designed to provide a regular stream of guaranteed payments in return for your initial investment. Some annuities pay out for a predetermined number of years; others pay out over your entire lifetime. Lifetime annuities are especially popular with retirees and those planning for retirement because they provide a steady cash flow that can protect against the risk of outliving one’s savings. Annuities can offer valuable tax-deferral advantages for high earners, and are a helpful tool for many individuals seeking financial stability in retirement.
There are two basic types of annuities – income and deferred
Income annuities typically start making regular payments right away – within one year of your initial investment – and may also called single premium immediate annuities. Because there is no delay in collecting income, immediate annuities can be a good fit for people who are almost at or already in retirement. Or, if you want to put off income payments for one or more years, you can also get a deferred income annuity.
Deferred annuities are also used as a savings vehicle, typically by those who are still years away from retirement and don’t need an immediate payout. These can be purchased with one or more payments, and your initial investment grows tax-deferred until you start taking regular withdrawals in retirement, so the payout is usually higher than you’d receive by making the same investment in an immediate annuity. As you’re waiting to start receiving regular income, you can choose to have annuity contributions grow in many way, including:
Fixed annuities offer a guaranteed interest rate with no market volatility – you know in advance how much your money will earn over time.
Fixed index annuities can be considered a “hybrid” of fixed and variable annuities. They offer a guaranteed minimal return (like fixed annuities) but are also tied to a stock market index, giving them the potential for added growth. The drawback? Index products typically have a cap that limits your returns, so in a year in which the market does especially well, you may only see a portion of the gains.
Other types of annuities, such as Variable Annuities or Registered Index-Linked Annuities, may also be available and can be discussed with your financial professional.
The choice of a fixed annuity, variable annuity, registered index-linked annuity or fixed indexed annuity often depends on a person’s risk tolerance. Please discuss this with your financial professional before making your decision.
Life Insurance | Annuity | |
Primary Purpose | Provide an income tax-free lump sum payment to beneficiaries in the event of policyholder’s death. | Provide a guaranteed income stream to annuity owner for a specified period or life. |
Payouts | Income tax-free lump sum at time of policyholder’s death. | Guaranteed payments to annuity owner for agreed upon term and frequency. Death benefit to beneficiary under certain circumstances. |
Underwriting Requirements | Medical examination. | No medical examination required. |
Age of Purchase | Generally younger people with dependents. | Generally those approaching or in retirement needing a guaranteed stream of income. |
Tax Considerations | Permanent life insurance offers the opportunity to accumulate cash value on a tax-deferred basis. Death benefit is usually income tax free for both permanent and term policies. | Annuities offer the opportunity to earn investment income or interest on a tax-deferred basis. |
Coverage Length | Term life insurance covers policyholder for the specified term – usually 10, 20 or 30 years. Permanent life insurance covers policyholder until death. | Annuities payments for the term specified at time of purchase. The term may be a set number of years, or until death. |
Potential Drawbacks | Term life insurance coverage is terminated at the end of the term. Permanent life insurance can be costly. Medical examinations typically required for both. | Annuities may have high annual fees. Early withdrawal of funds may result in high surrender charges and tax consequences. You may lose control of your principal. |
Life insurance and annuities can help protect your finances in different ways
Both are designed to provide financial protection, but they serve very different purposes and have distinct features.
Life insurance is primarily intended to provide a death benefit to your beneficiaries in the event of your passing – these income tax-free lump sum payments can help them handle day-to-day living expenses and other financial responsibilities in the absence of your income. In other words, life insurance can help protect your family from the risk of losing your income.
An annuity can be tailored to provide a payout to beneficiaries after your death, but that’s not the primary purpose. Annuities are designed to provide a guaranteed stream of income to live on, typically in retirement. And with a lifetime annuity, that income is guaranteed to last as long as you live. So, an annuity can help protect you from the risk of outliving all your money.
Which may be right for you? Possibly both.
As you can see, life insurance and annuities serve different purposes and are appropriate for different people, depending on their circumstances and financial needs
Life insurance is especially valuable for individuals who have financial dependents (spouse, children, etc.) and want to help ensure that their loved ones are financially protected if they can't be there to provide support. It can also be a valuable tool for business owners, who may use life insurance to protect their businesses and provide for succession planning, and people who want to help ensure that their debts will be paid off in the event of their death. And permanent life insurance, in particular (universal or whole life insurance), can be important for people who want to build family assets and provide an inheritance to their heirs.
Annuities are most appropriate for retirees (or those planning for retirement) who want to ensure a stable source of income during their retirement years. Deferred annuities can also be a useful savings tool for younger, high-earning individuals looking for tax-deferred growth.
Annuities and life insurance serve different primary purposes, and many should consider purchasing both. For example, a young, high-earning individual may need a life insurance policy to protect their family; at the same time, if they've maximized contributions to their tax-deferred IRAs and/or 401(k) plans, they could purchase and make unlimited contributions to an annuity and receive similar tax-deferred growth advantages. Some retirees may choose to purchase an annuity to help provide steady income payments during retirement while also maintaining a life insurance policy to provide support for their loved ones or cover outstanding debts in the event of their death. In addition, people with complex estate planning needs may use both annuities and cash value life insurance to achieve specific goals, such as helping to mitigate estate taxes, passing on wealth, or providing for charitable donations.
It's important to carefully assess your financial goals before purchasing annuities or life insurance. Speaking with a financial professional can help you determine the right financial product – or mix of financial products - to meet your individual needs and objectives.
Guardian can help
If you have questions regarding life insurance or annuities, take the next step: talk with an experienced professional who will take the time to learn about your unique situation and explain the different options that may fit your needs and your budget. If you don't know a financial professional, ask your friends for a recommendation – or click below to find a Guardian financial professional in your area.