Life insurance and annuities are two types of contracts offered by some insurance companies. Each product may help you meet specific financial goals, whether you want to leave a legacy when you die or supplement retirement savings during your lifetime.

Understanding how life insurance and annuities work can help you decide whether they deserve a place in your financial plan. In this guide, learn the differences between life insurance and annuities and how to decide which one’s right for you.

What is Life Insurance?

Life insurance is a contract between a policyholder and an insurer granting a payout when the insured individual dies. In exchange for regular payments, the insurance company agrees to compensate the policyholder’s named beneficiaries with the policy’s death benefit.

One of the main reasons people purchase life insurance is to protect loved ones who financially rely on them. Recipients can use the death benefit to supplement regular living expenses or pay for significant costs such as advanced education or a mortgage. The payout may also cover the policyholder’s funeral and burial expenses.

Life insurance acts as a safety net for beneficiaries. It gives policyholders peace of mind that their loved ones won’t face financial difficulties if they die unexpectedly.

Some forms of life insurance accumulate a cash value. The policyholder can access the cash value component during their lifetime to supplement income or pay for necessities.¹

Types of Life Insurance

There are different types of life insurance policies. Each falls into one of two categories: term and permanent coverage. Term life insurance lasts a specific period, while permanent coverage lasts an entire lifetime as long as the policyholder maintains their payments.

Term Life Insurance

Term life insurance covers a specific period ranging from 1 up to 30 years. During the term period, the policyholder pays the insurer regular payments per the term insurance policy’s contract. If the insured individual dies during the policy’s term, the policyholder’s beneficiaries receive a stipulated death benefit.

Unlike other forms of life insurance, term policies don’t last an entire lifetime. Once the term ends, coverage stops unless the policyholder purchases another term policy or converts their existing coverage into permanent life insurance.

A term policy doesn’t accumulate any cash value, which is one reason it’s cheaper than other types of life insurance. Payments offset the insurance company’s risk of the insured individual dying during the policy term. With a term life insurance policy, you won’t recoup payments or receive additional compensation if the policy expires before the insured’s death.²

A term policy’s payments remain the same throughout the contract. Once the policy expires, the insurance company may offer renewal options. However, your premiums may increase.

Whole Life Insurance

A whole life insurance policy includes two components: death benefits and accumulated cash value. The policyholder’s named beneficiaries receive the death benefit when the insured individual dies. However, the policyholder may access the policy’s accumulated cash value during their lifetime, which can supplement income or help pay for major expenses.

Whole life insurance policies last the policyholder’s entire life, so long as you keep up with payments. Your payment amount stays the same as long as the contract remains in effect. However, whole life insurance is more expensive than term policies since the insurer expects to pay death benefits and because the policy accumulates a cash value.

Insurance companies offer several ways to pay for whole life insurance. You may opt for regular periodic payments, like monthly or quarterly, or pay the policy’s entire premium upfront. Some insurers offer limited payments, where the policyholder makes payments over a specific timeframe, such as ten years before the insurance company considers it paid in full. Your insurance company will explain your payment options if you purchase a whole life policy.

Accessing the policy’s cash value during your lifetime is typically tax-free unless you’ve earned investment gains. If you die without ever using its cash value, it may pass back to the insurance company unless you purchase a rider designating the cash value to your beneficiaries. Some insurance companies allow you to take loans on a whole insurance policy. However, if there are any outstanding loans when you die, the insurer may reduce the policy’s death benefits by the loan’s remaining amount due.³

Universal Life Insurance

Universal life insurance is another type of permanent coverage. It lasts your entire lifetime, accumulates cash value, and pays death benefits to beneficiaries. However, it is much more flexible than a whole life policy since you may adjust its premiums to accommodate financial circumstances. For instance, you might pay high regular premiums during your working years and then request an adjustment to premium amounts when you retire.

While universal life insurance offers payment flexibility, your premiums must stay within a specific range to maintain coverage. Your insurance contract stipulates the payment range. If you opt for lower payments at any time, the policy’s accumulated cash value grows at a slower rate.

Some universal life insurance providers allow policyholders to take out a loan against their policy. If you opt to borrow money, you’ll make repayments until you satisfy the loan’s outstanding balance. Dying with an outstanding loan balance may reduce death benefits to your beneficiaries.

You may use the policy’s cash value to cover expenses, supplement your income, or for other financial needs.⁴ The cash value grows as you make regular payments and accumulate interest.

Universal life insurance is typically more affordable than whole life coverage but more expensive than term insurance.

Who Should Consider Life Insurance?

If others rely on you financially, you should consider life insurance. Here are a few situations where buying a policy makes sense.

Your Income Pays Household Expenses

If your family relies on your income for living expenses, like food and shelter, buying life insurance gives you peace of mind your loved ones won’t financially struggle if you die. The policy’s death benefits can replace your income as your family gets back on their feet.

You Care for Dependents

You may not have a traditional nine-to-five, but handle household tasks that are costly to hire out. Some examples include cooking, cleaning, and caring for young children or elderly adults. A life insurance policy may help family members pay to hire others to do those tasks in the event of your death.

You Worry About Paying Final Expenses for Others

Adult children may worry about paying for their parents’ funeral and burial services, especially if the parents don’t have much savings. Buying life insurance on a parent or other relative protects against unexpected out-of-pocket costs.⁵

You Want to Diversify Your Retirement Income

Purchasing permanent life insurance allows you to accumulate cash value over time. You may use your accumulated cash value to supplement your retirement income or pay for other expenses during your lifetime.

What is an Annuity?

Insurance companies sometimes offer annuities, a contract that guarantees income over a specific period. Consumers typically use annuities to supplement their retirement income, though you may access the income stream at other points in your lifetime, depending on the terms of the contract.

Purchasing an annuity requires an initial upfront payment or an agreement to make scheduled payments over a period of time. The payments form the annuity’s cash basis and grow tax-deferred until payouts begin. Some insurers allow annuity holders to access their account’s cash value up to a specific amount before payouts begin, although they may incur a penalty or fee to do so.

An annuity may hedge against the possibility of running out of retirement savings. It’s also a way to protect against rising inflation that erodes the value of savings accounts.⁶

Types of Annuities

There are many types of annuities. The four most common include fixed, variable, immediate, and deferred.

Fixed Annuity

Fixed annuities come with a guaranteed interest rate. The money you pay toward the annuity accumulates cash value plus interest at the specified rate. The rate stays the same for a specified period, such as five or ten years. After that period, the insurance company may adjust the rate — but it will never drop below the initial rate guaranteed.

You may buy a fixed annuity with a single upfront payment or agree to regular payments. Your payments build value over the annuity’s accumulation phase. You can start receiving annuity benefits once the annuity reaches the distribution period.

A fixed annuity’s distribution payments may last a set period, such as five or ten years, or throughout your lifetime. In general, a longer distribution period comes with lower annuity payments. Some fixed annuities allow you to withdraw the value in a single lump-sum payment, which may benefit retirees hoping to make a major purchase, like paying off their home’s mortgage.

If you die before claiming the entire value of an annuity, the remaining payments may go to a surviving spouse or designated beneficiary, depending on the contract’s terms.⁷

Variable Annuity

If you opt for a variable annuity, you’ll select from the insurer’s underlying investment options to build your account’s value^. You won’t receive a set interest rate. Instead, the annuity’s value depends on your investment’s performance.

Insurance companies that offer variable annuities typically allow buyers to select from mutual funds or money market instruments. Mutual funds may invest in different stocks and bonds. As long as your investments perform well, your annuity’s value grows. However, unlike fixed annuities, there is no guarantee of receiving a specific rate of return. There’s always the chance that a market downturn could wipe out some of your investment.

Variable annuities come with deferred or immediate payment options. A deferred structure allows the annuity to gain value over time as you make regular payments. Immediate annuities provide a regular source of instant income but usually require a significant upfront investment.

The upside of a variable annuity is its growth potential. Your underlying investment choices can outperform the guaranteed interest rate of a fixed annuity. It’s also customizable, allowing you to pick investments based on your risk tolerance and financial goals. However, if you go with a variable annuity, pay close attention to commission or management fees.⁸ Extra costs can cut into your earnings, reducing the annuity’s future value.

Immediate Annuity

An immediate annuity provides a shorter accumulation phase than fixed or variable annuities. It typically requires a large upfront payment, which the insurance company uses to build the annuity’s value. Annuity payments usually begin within a year of funding the contract and extend over a specific period, such as five or ten years.

Insurance companies may tie an immediate annuity’s growth to a set interest rate or the performance of specific mutual funds. Some insurers combine interest rates with the performance of a stock market index, such as the S&P 500, to boost the annuity’s value.

Immediate annuities may be attractive to those close to retirement who want to transfer their savings into scheduled annuity payments. They may also be useful for people who want to retire early but prefer to delay Social Security benefits to maximize their eventual payout.⁹ In such cases, the annuity holder may receive guaranteed income to finance their early retirement for several years, then withdraw Social Security once the annuity ends.

Deferred Annuity

Deferred annuities promise guaranteed income after you complete the accumulation period. The deferral period may extend to several decades, allowing significant time to build the annuity’s cash value component through premium payments.

You may purchase a deferred annuity with an upfront payment or by making regular payments over a period of time. Once you fully satisfy the annuity’s funding requirements, you’ll receive a stream of income payments. The payments can last several years or your entire lifetime. In rare cases, you may opt for a one-time payout in lieu of regular payments.

The annuity may build value according to a set interest rate or the performance of underlying securities such as mutual funds. You may incur fees if you cancel the annuity or withdraw some of its value during the surrender period, which typically lasts seven years or longer.¹⁰

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Who Should Consider an Annuity?

Annuities offer benefits to individuals concerned about having enough money in retirement. Here are a few reasons you might want to consider one.

You Worry About Running Out of Retirement Savings

Running out of savings is a major worry for retirees. An annuity can eliminate some of the anxiety by providing a guaranteed income stream.¹¹ Once you fund the annuity, you’ll receive regular payments to supplement other retirement income sources such as a pension or Social Security.

You Prefer Low-Risk Investments

Annuities generally provide less risk than other investment types, especially if you select a fixed annuity with a guaranteed interest rate. Even if you go for a variable annuity, you can select the underlying investments and choose ones with less volatility to protect the annuity’s value.¹¹

You Want Another Retirement Savings Vehicle

Annuities complement retirement savings vehicles like 401(k)s and IRAs. Many don’t have annual contribution limits, so they’re useful to people already maximizing their retirement savings in tax-advantaged accounts.¹¹ Of course, check with a financial advisor before committing to an annuity to verify you aren’t subject to contribution limits.

Key Differences Between Life Insurance and Annuities

Life insurance and annuities are two entirely different financial contracts. Both provide monetary benefits, but their payout structure, objectives, and tax treatment vary.

Payout Structures and Timelines

Life insurance offers financial security to designated beneficiaries if you die. Its purpose is to fill in income gaps and prevent economic fallout among your dependents if you’re not there to support them. While you may access some financial benefits through a life insurance policy while alive, that’s only the case if you purchase whole or universal life insurance. Term policies don’t include a cash value component, so you can’t use it to withdraw funds in a financial emergency.

Unlike life insurance, annuities help you achieve financial objectives while living. It may offer regular payments to supplement income when you retire. The income can supplement other earnings sources, including Social Security and pensions. Once you die, the remaining value of your annuity may return to the insurance company unless you make arrangements to designate a beneficiary for the remaining cash value. You may need to purchase an annuity rider to transfer the remaining funds upon your death.⁷

Risk and Investment Focus

Life insurance guarantees a death benefit to designated beneficiaries when you die so long as you make your premium payments. Your beneficiaries receive the death benefit regardless of stock market performance. As long as your death doesn’t fall into an exclusion category and your policy is in effect, your beneficiaries receive the funds.

Annuities come with some risk, depending on the contract’s type. For instance, a variable annuity’s value may vary depending on its underlying security’s performance. However, a fixed annuity carries less risk since it’s tied to an interest rate.

Tax Treatment of Life Insurance vs. Annuities

Most people pay life insurance premiums using after-tax dollars. However, the death benefit from a life insurance policy is usually tax-free, except in rare cases.¹²

Taxation for annuities is a bit more complex. If you pay for it using pre-tax money, you’ll owe income taxes once annuity income begins. However, if you purchase the annuity using after-tax dollars, you’ll owe money on any interest earnings or investment gains, not the premiums you pay.¹³

Estate Planning Implications

Life insurance is a common component of many estate plans. Purchasing it allows you to leave a financial legacy, even if you don’t have extensive savings or property to leave your heirs. In exchange for regular monthly payments, you can feel confident your loved ones won’t financially struggle if you’re no longer there to support them.

Annuities help people save for retirement and receive a steady income stream for several years — potentially until death. Any unused portion of an annuity may transfer to a designated beneficiary, provided that the owner stipulates the transfer in the contract or buys a rider.⁷ However, the financial benefits mostly benefit the annuitant during their lifetime, so an annuity isn’t a true estate planning tool.

Choosing the Right Option

Should you go with an annuity or life insurance? The answer depends on your financial goals and objectives.

If you want to provide financial security to beneficiaries when you die, life insurance is the clear choice. A life insurance policy offers death benefits to designated beneficiaries. The monies can pay your funeral expenses and provide a lump-sum payment for your beneficiaries’ living expenses and other necessities.

Soon-to-be retirees anxious about running out of retirement savings may benefit from an annuity. The annuity offers assured income payments for a period, complementing other sources like Social Security.

Speaking with a financial advisor can help you decide which option is right for you, given your circumstances and goals. A financial advisor may also help you select between the different life insurance and annuity options to obtain one that best aligns with your objectives.

Annuity or Life Insurance: You May Want Both

Annuities provide a source of extra income during retirement. Life insurance offers death benefits to designated beneficiaries, helping them stay afloat if you’re no longer there to support them. Features of annuities and life insurance may overlap in some ways. For instance, you may leave the remaining value of an annuity to a beneficiary or take out a loan on some types of life insurance policies to use during your lifetime.

Ultimately, deciding whether to buy an annuity or life insurance boils down to your financial goals. Purchasing an annuity may make sense if you’re worried about running out of retirement savings. On the other hand, life insurance allows you to leave a legacy to loved ones — something very important to parents and others with dependents.

When selecting between your options, think carefully about your objectives and individual circumstances. You might speak with a financial advisor for tailored advice. A financial advisor can explain the types of annuities and life insurance policies available to you and recommend options tailored to your goals.

Fidelity Life offers affordable life insurance policies, including term and permanent life insurance for seniors. To explore a life insurance policy with us, start a free online quote today.

At Fidelity Life, our goal is to make life insurance simple, affordable, and understandable for everyday families. This content is intended for educational purposes only. Each post is carefully fact-checked, reviewed, and updated regularly to ensure the information is as relevant as possible. We encourage you to speak with your insurance representative if you have additional questions and make sure you read your policy contract to fully understand your coverage.

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