Life Insurance vs Annuities Explained

Life insurance policies and annuities are both tools that help ensure future financial security. While they have some similar characteristics, there are also some important differences. Understanding how they differ can help you to make informed decisions when creating your financial and retirement planning strategies.

Read on to learn about both types of financial products, how each works and which might best suit your financial needs.

What is life insurance and how does it work?

Life insurance delivers a death benefit to your loved ones when you die. In return for payment of premiums, a life insurance company provides your beneficiaries with a financial payout if you pass away while covered by your policy.

Life insurance is often purchased to ensure that your survivors receive funds to replace, or at least offset, the loss of income you would have earned had you lived. It’s also secured to pay for major obligations such as paying a mortgage or college tuition, along with end-of-life costs like funeral expenses.

There are two main types of life insurance. As the name implies, term life insurance covers you for a certain number of years, after which the policy lapsers and has no value. Permanent life insurance (including whole life policies), by contrast, do not expire and have both a death benefit and a cash value; you can withdraw the latter, or take a loan against it, while you are alive.

Here’s a summary of how the types stack up on some key attributes:

This explainer gives more details on life insurance for beginners.

What are annuities and how do they work?

Annuities are designed to provide a steady stream of income now or in the future in return for payment of premiums. You can pay premiums in a single lump sum or spread them out over time.

Annuities, too, come in at least two flavors. Fixed annuities guarantee set payment amounts. Variable annuities let you choose how your money will be invested, and so payment amounts may vary – and not be guaranteed.

What is a life insurance annuity?

A life insurance annuity is a life insurance policy that pays out its death benefit in the form of an annuity. Normally, when a life insurance policyholder dies, their beneficiary receives a lump sum payment. But the beneficiary may not need or want a large sum of money at once.

If they instead opt to receive a life insurance annuity, the beneficiary receives the death benefit as a series of payments, say on a monthly basis. There is, however, a downside to a string of such payments. While lump-sum payments are usually tax-free, you may need to pay taxes and fees on payouts from a life insurance annuity. Also, an annuity will cost significantly more in payments than you’ll pay in premiums on a term life insurance policy.)

Key differences between life insurance vs annuities

Understanding the key differences between life insurance and annuities can help you decide which tool is right for you. Here are some of the main distinctions to be aware of.

Primary purpose and focus

The primary purpose of life insurance is to financially provide for your loved ones after you die. An annuity provides you with a stream of income throughout your retirement.

How payments are made

Life insurance payments are made to your beneficiaries after you die. Annuity payments are made directly to the annuitant while they're alive. The annuitant is usually, but not always, the person who purchases the policy.

Payout options

Life insurance companies usually pay out death benefits in one lump sum. An annuity is paid out at regular intervals, usually monthly, although you can choose to receive them more or less often than that.

Cash value component

Annuities always have a cash value component. This is the amount you've paid in premiums plus any accrued interest. Permanent life insurance also accumulates a cash value, although term life insurance doesn't. When you pay premiums toward a permanent life insurance policy, some is used to pay fees, another portion goes toward the death benefit and the rest adds to the policy’s cash value.

Investment component

Because term life insurance has no investment component, it doesn't have a cash value. Permanent life insurance does.

Both permanent life insurance and annuities may accumulate interest at a fixed rate, a rate based on stock market performance or through direct market investment, depending on the type of account.

Tax implications

Permanent life insurance and annuities are both ways to put aside money for tax-deferred growth. This deferral means you won't pay taxes on the money while it's in the account. Consequently, you’ll often enjoy faster growth of the product’s cash value, because you'll be earning interest on money that would otherwise be diverted to taxes.

If your beneficiaries receive a death benefit through your life insurance policy, they won't need to pay taxes as long as they take the payment as a lump sum.

However, if they choose to receive payments through an annuity, they'll be taxed on that income. Or a portion of it, anyway. When you receive annuity payouts, you'll only have to pay taxes on the portion that exceeds what was paid in premiums. The IRS considers the amount up to the total value of premiums to be a return of the investment, but any interest earned is considered taxable income.

If your policy has a cash value, you might withdraw cash or surrender the policy. In that case, you'll only have to pay interest on amounts you receive that exceed the premiums you paid.

Beneficiaries and annuitants

When you purchase a life insurance policy, you choose your beneficiary or beneficiaries. Beneficiaries can be:

• A person
• Multiple people
• Your estate
• A trustee, if you've set up a trust
• A charity

You can select primary and contingent beneficiaries. If your life insurance company can find your primary beneficiary, they will receive the death payout of your policy after you die. If your primary beneficiary isn't alive or can't be found, the death benefit will go to your contingent beneficiary.

When you purchase an annuity, it can be for yourself or another person. The person who will receive payments is considered the annuitant. The insurance company uses the annuitant's age and life expectancy to calculate the benefits.

Access to funds

Neither life insurance nor annuities should be considered as short-term savings tools. The death benefit of a life insurance policy isn't usually paid out until after you die. If your policy has a cash value, you may be able to make withdrawals or take loans from the cash value. You won't be able to access the cash value until it reaches a sufficient amount, which can take several years.

Annuities pay out a predetermined amount of money on a regular basis. The only access you'll have to the value of the annuity is through these payments. When you set up an annuity, you can choose between different types of annuities. If you're nearing retirement, you'll probably want an immediate annuity that starts paying within the first year. Deferred annuities, which start payments at a later date, are usually the best choice if retirement remains a way off.

Which is better, life insurance or annuities?

If you're trying to decide whether it's better to get life insurance or an annuity, take some time to consider your goals.

Are you trying to ensure your family will be financially secure if you die? If so, purchasing a policy from one of the best life insurance companies will be your best bet. But if your priority is making sure you'll have a reliable stream of income throughout your retirement, you'll probably be better off with an annuity.

If you need help clarifying your goals and choosing what tools will best help you reach them, consider consulting a financial planner. Many or most are committed – indeed, required – to serve your best financial interests, regardless of any benefit that may accrue to them for selling you a particular financial product – if they even make such sales, which some planners do not.

Summary of Money's life insurance vs annuity explained

Both life insurance and annuities are potentially valuable products to help ensure your financial security, or that of your family. However, the two have some key differences for which it’s wise to be aware.

Life insurance can sometimes be used as an investment too. Yet its most popular policies – of the term type – have no investment component. Rather, they’re designed only to provide for your family in the event you die when your loved ones are still dependent on you financially. They’re the most inexpensive option that provides such financial security.

By contrast, an annuity is an investment, not merely a vehicle that promises to pay a death benefit for a particular period. After paying premiums on the annuity, you'll receive guaranteed income throughout your retirement. Because they are so heavily geared to your retirement years, however, an annuity makes little sense for younger people, though. For them, a life insurance policy will be the better option.