Annuities vs. life insurance: which should you choose? Your answer lies in knowing the features of each product and what they offer. While both options are insurance products, how they pay you, the policyholder, varies. So let’s discuss these two products in more detail and how they can help you in your financial growth and independence.
Annuities vs. Life Insurance: An Overview
Permanent life insurance policies and annuity contracts may first seem like opposites. Life insurance provides an individual’s family with a lump-sum fiscal payout when that individual dies. However, annuities act as safety nets that provide a lifetime of guaranteed income streams. Both of these products are often marketed as tax-deferred alternatives to the usual stocks and bonds. They also have higher expenses that may dampen your investment returns.
Annuities and life insurance are both contracts between insurers (the financial institution) and policyholders (you). They both offer tax-deferred growth, and for some annuity contracts, death benefits may also accrue to beneficiaries. However, that’s where the similarities end. Although life insurance policies don’t provide a lifetime income (like annuities), you can always convert your life insurance to an annuity, tax-free.
You should note that annuities are not life insurance policies. They are designed to guarantee you, the policyholder, an income if you live longer than you expected. A life insurance policy only pays out in the event of your death. Now let’s talk about the different life insurance policies that are available.
Types of Life Insurance Policies
Life insurance helps you protect your dependents in the event of your passing. The types of policies include:
Simple Term Life Insurance
A term life insurance policy pays out a death benefit to your loved ones.
Permanent Life Insurance
These are also called cash-value policies since they also have a savings component. Therefore, the premiums tend to be far higher than those of the commensurate term policies. These savings can be accessed via tax-free loans for emergencies or investment opportunities.
As with annuities, permanent life insurance policies can be fixed or variable and they grow on a tax-deferred basis. Also, similar to term policies, they pay tax-free death benefits.
Whole Life Insurance
With these policies, insurance companies credit policyholders’ cash accounts based on the performance of conservative investment portfolios. There are fixed premiums for the life of the policy, and the value grows tax-deferred based on fixed interest rates.
Variable Life Insurance
These policies have higher growth potential as policyholders can choose a portfolio of stocks, bonds, and money market funds to invest in. Variable life insurance values and death benefits will fluctuate according to the performance of the underlying sub-accounts. If these sub-accounts consistently underperform, then the cash value may fall to zero, thus decreasing the death benefit.
The money in a policy’s cash/investment account grows on a tax-deferred basis. Unlike ordinary investment or savings accounts, you won’t have to pay taxes on any investment gains until you withdraw the funds.
Furthermore, these policies also offer you greater flexibility in your spending. For example, if your cash balance is high enough, you can take out tax-free loans to pay for unexpected expenses. The full death benefit will remain unchanged as long as you pay back the borrowed amount plus any accrued interest.
Life Insurance: Special Considerations
If you intend to use life insurance as an investment strategy, then you should take note of its drawbacks – like the high fees. Approximately half of your premiums go towards the sales rep’s commission. Therefore, it takes a while for the savings portion of your policy to gain traction.
You’ll not only need to pay upfront costs but also pay annual administrative and management fees. These fees may counteract the benefits of the funds’ tax-sheltered growth. It is also not clear what these fees are, and this makes it difficult to compare different companies. Unfortunately, many people let their policies lapse within a few years since they cannot keep up with the steep payment schedules.
Many fee-based financial planners may urge investors to buy lower-cost term insurance policies. They would then funnel the remaining funds into tax-advantaged retirement plans such as 401(k)s or IRAs. This approach means that you would pay smaller investment fees as you enjoy tax-deferred growth in your accounts.
If you have already maxed out your contributions to these tax-advantaged retirement accounts, cash-value policies are another alternative. These policies are quite prudent if you choose low-fee providers and you have the time to let your cash balances grow.
Also, high-net-worth individuals may place their cash-value policies inside irrevocable life insurance trusts to minimize their beneficiaries’ federal estate taxes (which can be as high as 40%).
Many individuals stay up late at night worrying about not having a large enough nest egg for retirement. Annuities exist to help address these concerns.
You can think of an annuity as a means to ensure that you have a regular income for the rest of your life. Annuities are designed to provide benefits while you are alive. Whether it’s guaranteed income, principal protection, interest rate CD type growth, long-term care/confinement care, or mutual fund type growth with a tax-deferred variable annuity, your chosen annuity will determine your contractual goal.
An annuity is a contract with an insurer where you agree to pay them a certain amount of money (either lump sum or via installments). Then you are entitled to receive a series of payments in the future. These payments often last for a specific time – for example, 10 years. Other annuities offer lifetime disbursements. In either case, you will have the financial cushion that you need.
The range of annuity products has significantly increased over the years. This is true even for fixed contracts that credit your account at a guaranteed rate and also variable contracts with returns attached to a basket of stock and bond funds. There are also indexed annuities where their performance is linked to a specific benchmark like the S&P 500 Index.
Annuities: Special Considerations
As with permanent life insurance policies, annuity products also command huge upfront commission fees that may erode long-term gains. They also have high surrender fees that are the penalties you pay for prematurely withdrawing funds from your annuity contract or canceling it completely. Therefore, an annuity’s funds may be tied up for as much as a decade. So as a policyholder, you may take a hit on your distributions in the first few years of the contract.
The tax treatment is also another concern with annuities. Although earnings grow on a tax-deferred basis, if you withdraw funds before you reach 59.5 years, any investment gains would be subject to ordinary capital gains taxes.
Annuities make the most sense for persons who may have a long life expectancy. If it is likely that you will get to age 90, a lifetime income stream is essential, especially if your 401(k) withdrawals and Social Security payments fall short.
If you are a younger investor, then variable annuities are only recommended if you’ve maxed out your 401(k) and IRA contributions and seek tax shelters.
Qualified vs. Non-Qualified Annuities
The previously mentioned annuities are in the non-qualified annuities. However, qualified annuity contracts are those held in IRAs or other tax-advantaged retirement plans like 401(k)s. A qualified annuity is funded with pre-tax dollars and a non-qualified annuity is funded with post-tax dollars.
These qualified annuity contracts are subject to the same early withdrawal penalty. Also, there are required minimum distribution (RMD) rules as well as other investments in qualified retirement plans.
Contact Riegelwood FCU to Plan for Your Future
We’ve explored the distinction between annuities vs. life insurance policies. At Riegelwood Federal Credit Union, we will help you plan for your future and the futures of your loved ones. Whether it’s life insurance or investments, we’ve got you covered. So contact us today to begin the journey to a better and more secure tomorrow for you and your family.