Understanding Annuity Value Life Insurance Benefits

Life insurance and annuities are two financial products that are often confused with each other. While they are both offered by life insurance companies, they serve different purposes. Life insurance is primarily used to pay your beneficiaries when you pass away, while an annuity is designed to grow your savings and pay you an income while you are still alive. Annuities are usually bought by retirees and can be funded by a lump-sum payment or periodic payments. They are a form of insurance against outliving your savings.

Annuity vs. life insurance: What are the differences?

Annuities and life insurance are both insurance products, but they differ in how they pay policyholders. Life insurance is primarily used to pay your beneficiaries when you pass away, while an annuity grows your savings and pays you an income while you're still alive. However, there is some overlap, as some life insurance policies let you build savings while alive, and annuities can include a death benefit payment.

Benefits

The primary benefit of a life insurance policy is the death benefit that is paid to your loved ones when you pass away. The primary benefit of an annuity is the pension-like stream of income you will receive in retirement.

Payouts

Life insurance typically pays the death benefit in one lump sum, while annuities usually pay benefits monthly over time.

Beneficiaries

With an annuity, you (and sometimes your spouse) are the primary beneficiary, so you receive all income payments. With life insurance, your spouse, children, or other designated heirs are the primary beneficiaries, so they will receive the death benefit after you pass away.

Underwriting

With life insurance, you usually have to apply for coverage, and your acceptance is often based on factors such as your age and health. No underwriting is required for an annuity; however, there may be some age restrictions on the benefits you select, and the amount of income paid is dependent on your age and gender, among other things.

Time frame

Annuities are typically purchased later in life as a way to provide additional income in retirement. Life insurance is often purchased earlier, when the death benefit protection may be more important to your loved ones.

Funding

Life insurance policies are usually funded by monthly or annual premiums (payments) that you make over time, while annuities are usually funded in one or more lump-sum payments.

Early access to money

Life insurance is better for early access to your money, especially if you might need the money before retirement. Once you have cash value, you can withdraw or borrow it at your convenience. There are no age requirements for when you can take out the money.

With an annuity, you agree to keep your money in the contract for a minimum number of years. If you make a large lump sum withdrawal or cancel before the agreed date, the insurance company will deduct a sizable surrender fee.

Conversions

You can convert your life insurance to an annuity if your life insurance has cash value. The annuity will then invest and generate income based on your cash value balance. You give up the life insurance death benefit for more income and investment guarantees. However, you cannot convert an annuity into life insurance.

How do you choose between an annuity and life insurance?

Annuities and life insurance are both insurance products offered by insurance companies. However, they are designed for different purposes and cater to different needs. Here is a detailed comparison to help you choose between an annuity and life insurance:

Benefits:

The primary benefit of life insurance is the death benefit paid to your loved ones when you pass away. Life insurance ensures your family's financial well-being after your death. On the other hand, the main advantage of an annuity is the pension-like stream of income it provides during your retirement years. Annuities help protect your financial well-being by providing a steady income when you are no longer earning.

Payouts:

Life insurance typically pays the death benefit in a lump sum to the beneficiaries. In contrast, annuities usually pay benefits in monthly instalments over time. With an annuity, you can choose to receive payments over a fixed period or opt for guaranteed income for life.

Beneficiaries:

With an annuity, you are generally the primary beneficiary, and in some cases, your spouse may also be a beneficiary. You receive all the income payments. Conversely, with life insurance, your spouse, children, or other designated heirs are the primary beneficiaries and will receive the death benefit after your demise.

Underwriting:

Life insurance usually requires you to apply for coverage, and your acceptance is based on factors such as age and health. A medical exam is often necessary to qualify for coverage. In contrast, annuities do not require underwriting, and anyone can qualify as long as they have the money to buy the contract. However, there may be age restrictions on the benefits and the amount of income paid may depend on age, gender, and other factors.

Time Frame:

Annuities are typically purchased later in life to provide additional income during retirement. On the other hand, life insurance is often bought earlier in life when the death benefit protection is more crucial for your loved ones.

Funding:

Life insurance policies are commonly funded through monthly or annual premiums paid over time. In contrast, annuities are usually funded through one or more lump-sum payments.

Choosing Between Annuity and Life Insurance:

When deciding between an annuity and life insurance, consider your specific needs and circumstances.

Choose life insurance if:

• You want to ensure your loved ones are financially secure after your death.
• You have dependents who rely on your income.
• You have significant financial obligations, such as a mortgage or business loans.
• You are looking for a tax-free way to leave money to your beneficiaries.
• You want a tax-efficient way to accumulate wealth through the cash value of the policy (whole life insurance).
• You need affordable protection while building other assets (term life insurance).

Choose an annuity if:

• You are concerned about having sufficient income during retirement.
• You want to create an additional source of income for your retirement.
• You expect to live a long life and want "longevity insurance."
• You want to transfer some financial risk to your insurance company.
• You are looking for a straightforward way to meet your required minimum distributions (RMDs).
• Your Social Security benefits are insufficient to cover your basic expenses.

In summary, choose life insurance if you want to provide financial protection for your loved ones after your death. On the other hand, select an annuity if you want to guarantee a steady income during your retirement years and are concerned about outliving your savings.

What are the benefits of an annuity?

Annuities are insurance products that can guarantee a steady income stream for life, ensuring financial stability and peace of mind during retirement. They are especially beneficial for those without traditional pensions, as annuities can provide a similar level of security. Here are some of the key benefits of annuities:

Guaranteed Income

Annuities are the only financial product that can provide a guaranteed lifetime income, ensuring you never outlive your savings. This is particularly valuable for those concerned about their retirement savings lasting their lifetime. With an annuity, you can rest assured that you will always have an income to rely on.

Tax Advantages

Annuities offer tax-deferred growth, meaning you don't pay taxes on the interest until you start receiving payments. This allows your money to grow more over time, as earned interest compounds without taxes reducing your balance. Additionally, you may be able to benefit from lower taxes in retirement if you fall into a lower tax bracket due to a reduced income.

Unlimited Contributions

Unlike other retirement options such as IRAs and 401(k)s, annuities have no IRS contribution limits. This means you can contribute as much as you want, making them a flexible option for those who want to save more for retirement.

Customization Options

Annuities are highly customizable and can be tailored to meet your specific needs. You can choose between immediate and deferred annuities, fixed or variable rates, and add riders for additional benefits such as long-term care insurance or death benefits. This flexibility allows you to design an annuity that aligns with your retirement goals.

Long-Term Care Insurance Riders

Annuities may offer riders that provide extra payments for long-term care, serving as a cost-effective alternative to traditional long-term care insurance. This can be especially beneficial for those who may have pre-existing conditions or health concerns that make obtaining traditional long-term care insurance difficult or expensive.

Protection and Simplicity

Annuities can provide greater protection against elder fraud and abuse compared to an investment portfolio alone. They also offer simplicity and predictability, as you receive a regular, consistent income without the complexity of managing an investment portfolio.

How do annuities work?

Annuities are a type of insurance contract designed to turn your money into future income payments. They are typically used as part of a retirement strategy to ensure a steady flow of income during one's post-employment years. Annuities are sold by insurance companies but can also be obtained through a bank or brokerage firm.

Annuities work by providing a regular, guaranteed income stream over a specified period or for the rest of a person's life. They are often used by individuals who want a stable, guaranteed retirement income. The money placed in an annuity is illiquid and subject to withdrawal penalties, so this option is not recommended for younger individuals or those with liquidity needs.

There are several types of annuities to choose from, including immediate and deferred annuities, as well as fixed, variable, or indexed annuities. Immediate annuities begin paying out immediately upon deposit of a lump sum, while deferred annuities are structured to grow on a tax-deferred basis and provide income at a specified future date. Fixed annuities provide a guaranteed minimum rate of interest and fixed periodic payments, while variable annuities allow the owner to receive larger or smaller payments depending on the performance of the annuity fund's investments. Indexed annuities are fixed annuities that provide a return based on the performance of an equity index.

When setting up an annuity contract, participants select the type of annuity and pay into a plan purchased through an insurance company, bank, or broker. The insurance company then invests the payment, and the account earns interest. Once the annuitant decides to receive payments, they will receive the original investment plus interest, minus any fees. It's important to note that money invested in an annuity is usually not accessible until the payout begins, and there may be penalties for early withdrawal.

What are the tax implications of annuities?

Annuities are a type of insurance contract designed to turn your money into future income payments. They are taxable based on the type of annuity you have and when you withdraw funds. Taxes are determined by the specific type of annuity purchased—either qualified or non-qualified. The taxability of annuity payouts generally depends on whether pre-tax or after-tax money was used to fund the annuity.

Qualified Annuities

Qualified annuities are generally funded with pre-tax dollars, though Roth annuities are funded with after-tax money. They are subject to required minimum distribution (RMD) guidelines unless it is a Roth IRA (Roth 401(k)s will no longer be subject to RMDs in 2024). You must begin taking distributions from a qualified annuity by April 1st of the year after you reach your RMD age, which is currently 73 and will increase to 75 in 2033. You will pay normal income taxes on the entire distribution amount. Annuities purchased with a Roth IRA or Roth 401(k) may be tax-free if specific requirements are met.

Non-Qualified Annuities

Non-qualified annuities are funded with after-tax dollars and grow tax-deferred. They are exempt from RMD guidelines during life. Once you start taking distributions from a non-qualified annuity, any interest or earnings within the annuity will be distributed before the premium or principal amount. The distributions of interest (or earnings) are taxed as ordinary income, but you won't pay taxes on distributions of the premium or principal you initially deposited.

Tax Implications of Withdrawing from an Annuity

If you make a withdrawal from your annuity prior to the designated time period, you can expect to pay early withdrawal penalties. Withdrawals made before you reach age 59½ are typically subject to a 10% early withdrawal penalty tax. For early withdrawals from a pre-tax qualified annuity, the entire distribution amount may be subject to the penalty. If you withdraw money early from a non-qualified annuity, typically only earnings and interest will be subject to the penalty.

Other Tax Considerations

Contributions to non-qualified annuities aren't deductible, but you don't pay taxes on the earnings until you withdraw the money. Qualified annuities, often part of retirement plans like 401(k)s and 403(b)s, have IRS-imposed contribution limits, while non-qualified annuities don't. With a non-qualified annuity, any 10% early withdrawal penalty would be on earnings only, not the principal. Non-qualified annuities also don't require you to take RMDs. However, the IRS requires owners of most qualified annuities to take distributions, generally starting at age 73.

Frequently asked questions