Annuities vs Life Insurance:
Retirement is probably the biggest topic on the minds of seniors. One of the biggest questions we get asked by our clients is what exactly is the difference between annuities and permanent life insurance policies?
We understand the confusion. At a glance it seems as though whole life insurance and annuities have a bit in common: both are tax-deferred alternatives to traditional investment vehicles (such as stocks and bonds).
Additionally, each option comes with high expenses.
Permanent life insurance policies offer a lump-sum payout to your family when you pass, and annuities provide financial safety nets with guaranteed income streams.
However, the income streams provided by each option have quite a few differences.
In this article we will review the basics of annuities and life insurance policies, in order to help you decide which option is best for you.
What are Annuities?
Many seniors worry that they have not saved enough to see them through their retirement years. In fact, according to a Northwestern Mutual report from 2019, 46% of respondents did not know how much they have saved for retirement. Even more alarming: a mere 16% reported having $200,000 or more saved for retirement.
Annuities were developed as a solution to retirement concerns. An annuity is a contract with an insurer, where you pay a set amount of money – either in installments or a lump sum – in exchange for a series of future payments. The payment disbursements often last a specific timespan, typically 10 years. Occasionally, annuities offer lifetime payment disbursements.
There are a number of annuity products available, including:
- Variable contract annuities, where returns are tied to stock and bond funds
- Fixed contract annuities, which credit your account at a guaranteed rate
- Indexed annuities, where the performance of your returns are linked to a specific financial benchmark (usually the performance of the S&P 500 Index
The earnings in each annuity product grow, tax-deferred. However, if you withdraw funds before you reach 59 ½ years of age, your gains will be subject to taxes.
Like whole life insurance, annuities come with high upfront fees. They also come with large penalties for early withdrawal or cancellation. In fact, because of this, annuity funds may be ties up for as long as ten years before you receive a pay out.
Annuities make the most sense for those with an estimated long lifespan, as a steady income in later years can be a great supplement to 401(k) and Social Security funds.
Qualified vs Non-Qualified Annuities
Variable contract, fixed contract and indexed annuities are all non-qualified annuities. A qualified annuity is held in tax-advantaged retirement plans, such as 401(k) or an IRA.
Qualified annuity contracts follow the same required minimum distribution (RMD) rules and early withdrawal penalties as other qualified retirement investments.
The main difference: qualified annuities are funded with pre-tax dollars, and non-qualified annuities are funded with post-tax dollars.
Life Insurance: The Basics
If you have read the rest of our blog, you should already know a bit about the basics of life insurance. The idea behind life insurance is to provide a financial cushion for your loved ones and dependents should you pass away.
Like annuities, life insurance offers many products.
- Term life insurance. In exchange for set premiums over a set term (from 5 to 35 years), your loved ones will receive a lump-sum death benefit.
- Permanent life insurance. This is also referred to as a “cash-value” policy. Like term life, you pay premiums in exchange for lifelong coverage. The main difference is that these policies accrue a cash value savings component. The premiums with this policy are also higher than term life.
- Whole life insurance. Your premiums and cash value are based on the performance of an investment portfolio.
- Variable life insurance allows you to choose money market funds, stocks, or bonds to increase policy growth. The downside to this type of insurance is underperforming investments will directly impact your policy’s growth.
For the purposes of this article, we will be focusing primarily on cash-value policies.
The money in these policies grows on a tax-deferred basis, and you will not pay taxes unless you actually withdraw the funds. However, these policies often offer flexible spending options.
If you have a high enough cash balance, you may be able to take out tax-free loans. These loans can be used to pay for medical expenses or other unexpected needs (keep in mind: these are not large loans, so they may not be large enough to cover medical expenses). As long as you pay back the amount you borrowed (and interest), your full death benefit will remain intact.
Life Insurance as an Investment Vehicle
Before you read on: if you have not read our article on why life insurance should not be used to fund retirement, you should take the time now to do so.
There are several drawbacks to using your life insurance policy as an investment strategy. Especially because whole, permanent, and variable policies take some time to grow.
Additionally, the upfront premium costs on these policies are high – and often aren’t the only costs associated with these policies. Occasionally, policyholders pay management and administrative fees for cash-value plans.
We always recommend finding a term life insurance policy and using alternative methods for saving for retirement and your later years. Term life insurance policies are less expensive and offer a larger death benefit to your dependents.
A rule of thumb we like for anyone considering using life insurance as an investment tool: talk to an agent about your term choices.
Then, compare the differences in premiums and invest that difference into a tax-advantage retirement plan. This way you are paying less for more coverage while enjoying tax-deferred account growth.
If you have already maxed out your contributions to a tax-deferred account, a cash-value plan might be a decent option. Keep in mind: you want ot be sure the provider you are choosing offers low fees – and that you are providing yourself with enough time to let your accounts grow.
Life insurance is for protecting your beneficiaries after you pass away. Cash-value accounts are only right for certain financial situations, and you should always speak to a trusted agent before purchasing any type of life insurance coverage.
Annuities are excellent tools for boosting your investments, but should not be considered in place of life insurance coverage.
A solid financial adviser and a trusted independent agent can work together to help you form a solid financial plan for your retirement years and beyond.