What is the Difference Between Life Insurance and Annuity?

How the two insurance products differ when it comes to paying policyholders

Life insurance and annuity can easily be mistaken as the same thing. However, that’s not the case. While both are insurance policies, they have different ways of paying out policyholders.

Since both policies are often marketed as tax deferred alternatives, it is easy to assume there might not be much difference between the two when in reality, life insurance and annuity are stark opposite policies. To determine which one would be better suited to your needs, first we have to see what the difference between life insurance and annuity is.

What is Life Insurance?

Life insurance is a type of permanent insurance that focuses on paying the policyholder’s family a lump sum amount in the event of your passing. There are various types of life insurance policies and they all perform different functions and cater to different ages.

Types of Life Insurance:

1.    Simple Term Policy

A term life policy states the time period after which it expires. If you were to die before the stated time period is up, your family would receive the death benefit. This is usually not for retired people who are only looking to secure a death benefit. People between the ages of 35-60 are the ones likely to purchase this policy plan.

2.    Permanent Life Policy

Permanent life policies are sometimes also referred to as cash value prices because of the cash accumulation aspect of the policy with a savings element. People like to purchase this plan when they want to save their money while having permanent life insurance. This policy is mostly purchased by young people who are earning good but because of a serious illness they might have, they want to save their money for their family after they pass away.

3.    Whole Life Policy

A whole life insurance policy includes an investment opportunity for policyholders who then receive the profit from various independent companies depending on their performance. This policy is best for people who want to use their money for investment purposes while getting life insurance.

4.    Variable Life Policy

A variable life essentially increases a company’s growth potential by letting the policyholders choose a stock, bond and money market funds to invest in. These policies also carry an underlying risk of these stocks and funds of not performing as the policyholder had hoped. It’s useful for people with enough money to invest in these stocks and funds.

It’s important to know that the investment element of life insurance policies also have some drawbacks. These can concur high fees that might even be more than you initially planned for. Roughly half of your premiums can go towards paying the sales representative’s commission. Consequently, the savings component can take a while to start gaining traction.

Along with the upfront costs, policyholders may have to pay administrative and management fees. Usually, it is unclear what exactly these fees are, making it difficult to compare providers. It’s common for people to let their policies lapse in the first few years because they aren’t able to maintain the steep payment schedules.

Now to see what the difference between life insurance and annuity is, we have to look at annuities in detail too.

What is Annuities?

Annuities, also known as immediate annuities, is essentially a contract with an insurer where the insured pays either a lump sum amount or installments after which they are entitled to receive a series of payments at a later date. These policies last for a specific time period, for example, 10 years.

It provides a financial cushion for people to fall back to once they are retired.

Unfortunately, just like life insurance policies, annuities also demand upfront commission fees that can erode any long term gains. They also have high surrender fees, which is an amount that the policyholder would have to pay in case they prematurely withdraw from the fund or cancel it altogether. This makes it difficult to compare and find out the best annuity rates.

With an annuity policy, there’s also a concern for tax treatment. If the policyholder withdraws funds before reaching the age of 60, the investment gains would be subject to capital gains.

For all these reasons, it is most common for policyholders to opt for annuities when they have longevity in their family. For people reaching till 90, it is important to have lifetime income especially if their 401(k) withdrawals and social security payments fall short.

For people who are younger, variable annuities are a good option if they have already maxed out their 401(k) and IRA contributions and want to seek tax shelter. These fall under non-qualified annuities which are funded with post-tax dollars.

Qualified annuity falls under IRAs and 410(k)s and are funded with pre-tax dollars. Like other investments in qualified retirement plans, qualified annuity is also subject to required minimum distribution (RMD) and early withdrawal penalty.

What is the bottom line?

The bottom line is, many people choose to purchase both life insurance annuity to meet different goals and demands. It is essential to consider what life insurance and annuity have to offer when you are considering the financial plan for both you and your loved ones. Once you know the extent of the policies, only then can you make an informed decision about which policy is better suited to your needs. There’s not much difference between life insurance and annuity but there’s enough for you to decide according to your preference and financial goals.

When deciding which policy to opt for, you need to take a good look at your current financial situation and what you think it will be like in the future.

 

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Nabeel Ahmad

Nabeel Ahmad

Nabeel Ahmad is the founder and editor-in-chief of Insurance Noon. Apart from Insurance Noon, he is a serial entrepreneur, and has founded multiple successful companies in different industries.

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