You want to plan for retirement, yet there are so many uncertainties – life expectancy, the size of your nest egg, market volatility, and finally, health concerns to top it all off. You seek stability, a safety net, and perhaps something to leave your loved ones. Who do you turn to? Where do you turn to? Better yet, what do you turn to?
A perhaps surprising solution is life insurance, or its alternative, the annuity. Depending on your situation, one may be more suitable than the other. The trick is to know the difference between the two, which may not be immediately obvious – both can offer living benefits, a death benefit, and tax-deferred or tax-free growth.
Before we go into the intricate differences between life insurance and annuities, let’s ensure we have a basic understanding of each. Take note that this is just a quick breakdown – each product has a multitude of benefits, options, nuances, and rules we don’t go into here. For a more thorough analysis of each, feel free to read our articles on cash-value life insurance and annuities.
Modern Life Insurance
This may be a confusing one – isn’t life insurance there to provide financial security for loved ones after you’ve passed? Not necessarily – though that’s, of course, more than possible, and with Term Life Insurance, that’s essentially its primary purpose..
However, contemporary life insurance policies, like Whole or Universal, offer multiple benefits not found in Term. Perhaps most importantly, they can build up cash value over time, allowing you to then remove a portion of that cash value in the form of a loan, which would then be subtracted from your death benefit if not repaid. If none of the built-up cash value is withdrawn, your beneficiaries will get the entire portion of the death benefit as long as all other rules are followed and premiums paid.*
*It’s important to note that the death benefit is separate from the cash value. In many policies, if you pass away, your beneficiaries receive the death benefit, but the insurance company retains the cash value.
Annuities
An annuity is a contract between you and an insurance company. In this contract, you can make one or multiple payments to the insurer. In return, the insurer commits to making periodic payments or a lump sum payment to you – either immediately or at a future date, depending on the terms of the contract.
The primary purpose of an annuity is to provide steady and predictable income within your desired timeframe. You can set it up so it starts making payments at about the same time your savings start to run out or use the various possible riders to help pay for long-term care expenses or provide a death benefit – the options are nearly endless.
So, what’s the difference?
Primary Function
Life Insurance: Focuses on providing financial protection against premature death.
Annuity: Designed primarily to offer income payments to the annuitant, either immediately or at a future date, possibly to safeguard against outliving one’s savings.
As mentioned above, life insurance can serve as a financial cushion, and an annuity can provide a death benefit, but the core function of each remains the same.
Health Underwriting
Life Insurance: May require a medical exam, health questionnaire, or review of medical records, all of which can affect your premiums and eligibility.
Annuity: No health underwriting or medical exams are typically needed to purchase. Health does not affect the terms or rates.
While many annuities do hold age limitations, they generally have fewer barriers to entry than life insurance, especially for those with health problems. So even if you fail to receive cash value life insurance, you’re not completely locked out of a financial safety net.
Funding Method
Life Insurance: Premiums are typically paid periodically to maintain the policy.
Annuity: Can be funded with a single lump sum payment or a series of payments.
This is pretty self-explanatory – insurance is well-known for its premiums. With permanent life insurance, you can generally expect to pay a monthly premium, the amount and duration of which depends on your specific contract. Annuities may also have the option of monthly payments, but lump-sum payments are also standard.
Tax Implications
Life Insurance: Death benefits pass to beneficiaries generally tax-free.
Annuity: Withdrawals are taxed at ordinary income rates, and there might be penalties if withdrawn before age 59½.
Life insurance policies, especially the death benefit, come with the advantage of being typically tax-free for beneficiaries. Annuities, though they offer tax-deferred growth, oblige you to pay taxes on the earnings once you receive payouts.
Estate Planning Tool
Life Insurance: More effective at creating a substantial inheritance for heirs due to the potential for a more considerable death benefit. Death benefits are typically received income-tax-free by beneficiaries.
Annuity: Generally provides more minor death benefits compared to life insurance. Heirs may owe income tax on annuity investment earnings.
When it comes to estate planning, life insurance is a key tool for leaving a sizable, tax-free inheritance. While annuities can also offer inheritance benefits, they might have tax implications for heirs. Both options have their strengths; the decision should be based on legacy goals and tax factors.
Access to Your Money
Life Insurance: Allows for more flexibility with early access to funds.
Annuity: Commits funds for a specific period; withdrawing before this time incurs surrender charges and possibly penalties.
A significant factor here is age. The IRS may add on a 10% ‘early withdrawal penalty’ to annuity payouts before reaching the age of 59 ½, similar to a retirement account like an IRA or 401(K). Life insurance policies generally allow you to borrow against your cash value at any time without any specific penalty – you just need enough cash value to borrow against.
Final Thoughts
Both life insurance and annuities present unique benefits that can be tailored to your retirement needs. The core of the decision lies in understanding their primary functions, the associated costs, and the tax implications.
Neither is inherently better than the other; it’s about which aligns more closely with your goals and circumstances. In very general terms, an annuity focuses more on providing a guaranteed income stream in the later years of your life, while cash value insurance focuses on providing a death benefit while also serving as a financial cushion when needed – but the primary functions of these products are not set in stone.
Remember, always consult with a financial professional to ensure that you’re making informed decisions that will truly serve your best interests in the long run.
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