Life Insurance vs. Annuity: An Overview
At first glance, permanent life insurance policies and annuity contracts exhibit polar opposite goals. While life insurance seeks to provide an individual's family with a lump-sum fiscal payout when that individual dies, annuities act as safety nets by providing individuals with a lifetime of guaranteed income streams. Both products are often marketed as tax-deferred alternatives to traditional stock and bond investments. They each also have high expenses that can blunt investment returns.
- Life insurance and annuities both allow individuals to invest on a tax-deferred basis.
- Life insurance pays an individual's loved ones after they die.
- Annuities take payments upfront then dole out a lifelong income stream to policyholders until they die.
- Qualified annuities are funded with pre-tax dollars, and non-qualified annuities with post-tax dollars.
- Both life insurance and annuities tend to have hefty fees.
Life insurance financially safeguards your dependents in the event of your passing. There are several types of policies:
Simple Term Life
Sometimes referred to as cash-value policies, these products add a savings component. For this reason, the premiums tend to have substantially higher fees than those associated with commensurate term policies.
These life insurance products increase a policy's growth potential by letting policyholders choose a basket of stock, bond, and money market funds to invest in. But variable life policies also carry increased risk if the underlying investments underperform.
The money in a policy's cash/investment account grows on a tax-deferred basis. Unlike ordinary investment or savings accounts, consumers do not pay taxes on investment gains until the funds are actually withdrawn. These policies also offer spending flexibility. For example, if your cash balance is high enough, you can take out tax-free loans to pay for unexpected needs. The full death benefit will remain intact, as long as you pay the account back the borrowed amount, plus any accrued interest.
The younger you are, the lower your premiums—but older people can still purchase a life insurance policy.
Special Considerations for Life Insurance
It's important to know that the use of life insurance as an investment strategy has drawbacks, including high fees. Roughly half of a policyholder's premiums go toward the sales representative's commission. Consequently, it takes a while for the savings component of a policy to start gaining traction.
In addition to the upfront costs, policyholders must pay annual administrative and management fees, which can counteract the benefits of the funds' tax-sheltered growth. Furthermore, it is often unclear what the fees are, making it difficult to compare providers. Sadly, many people let their policies lapse within the first few years because they cannot maintain the steep payment schedules.
Many fee-based financial planners urge investors to purchase lower-cost term insurance policies, then funnel the leftover funds that would have gone toward permanent life premiums into tax-advantaged retirement plans such as 401(k)s or IRAs. This approach lets policyholders pay smaller investment fees, while still enjoying tax-deferred growth in their accounts.
Of course, for individuals who have already maxed their contributions to these tax-advantaged retirement accounts, cash value policies may be prudent—especially if they choose low-fee providers and have the time needed to let their cash balances grow. In addition, high-net-worth individuals sometimes park cash value policies inside irrevocable life insurance trusts in order to minimize their beneficiaries' federal estate taxes, which can be as high as 40%.
Many people worry that they will not have a big enough nest egg to see them through their retirement years. Annuities were developed to help alleviate these concerns. An annuity is essentially a contract with an insurer, where individuals agree to pay the company a certain amount of money, either in a lump sum or through installments, which entitles them to receive a series of payments at some future date. These payments often last for a specific time span—say, 10 years. Other annuities offer lifetime disbursements. In either case, policyholders know they'll have a financial cushion.
The number of annuity products has exploded over the years. This holds true for fixed contracts that credit your account at a guaranteed rate, as well as variable contracts, whose returns are attached to a basket of stock and bond funds. There are even indexed annuities, where performance is linked to a specific benchmark, such as the S&P 500 Index.
Special Considerations for Annuities
Unfortunately, as with permanent life insurance policies, annuity products also command substantial upfront commission fees that can erode long-term gains. They also feature high surrender fees, which are essentially penalties investors must pay for prematurely withdrawing funds from an annuity contract, or canceling it altogether. For this reason, an annuity's funds may be tied up for as much as a decade. It's not unusual for a policyholder to take a hit on distributions taken during the first few years of the contract.
Tax treatment is also a concern. Although earnings grow on a tax-deferred basis, if a policyholder withdraws funds before they reach the age of 59½, any investment gains would be subject to ordinary capital gains taxes.
For all of these reasons, annuities make the most sense for individuals with longevity in their families. For individuals likely to reach age 90, a lifetime income stream is essential, especially if their 401(k) withdrawals and Social Security payments fall short.
For younger investors, variable annuities are only prudent if they've already maxed out their 401(k) and IRA contributions and seek tax shelters.
Qualified vs. Non-Qualified Annuities
The aforementioned annuities fall under the category of non-qualified. 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 with post-tax dollars.
Qualified annuity contracts are subject to the same early withdrawal penalty and required minimum distribution (RMD) rules as other investments in qualified retirement plans.
On March 27, 2020, former President Donald Trump signed a $2 trillion coronavirus emergency stimulus package, called the CARES (Coronavirus Aid, Relief, and Economic Security) Act, into law. The CARES Act waives the 10% tax penalty for early withdrawals from retirement funds, including qualified annuities, if the withdrawals are related to the financial impact of the coronavirus. The waiver is retroactive to Jan. 1, 2020. You are also not subject to an RMD from your retirement account in 2020.