Life Insurance and Annuity: What's the Difference?

Being an adult requires making financial decisions each day, including how much you want to spend on a house and how much life insurance you should carry. To make matters more confusing, there are financial products like life insurance and annuities that are similar, but different. Here, we help untangle the similarities and differences.

What is a life insurance annuity?

What is a life insurance annuity? Let's say a man named Bob has a life insurance policy for $500,000, and his beneficiary is his wife, Laura. Bob dies, and the insurance company offers Laura several ways to accept the $500,000 death benefit.

• Take a lump-sum payment. This is the most common method of receiving life insurance proceeds. It's as simple as the insurance company mailing a check or depositing the funds directly in the beneficiary's bank account.
• Request installment payments. Laura feels overwhelmed. She decides that she would rather receive a check each month for $2,000 and allow the insurance company to look after the $500,000. Once papers are signed, the insurer puts $500,000 in an interest-bearing account on Laura's behalf and begins sending monthly payments of $2,000. Not counting interest earned on the money, there's enough in the account to last for about 21 years.
• Create an annuity. Laura still doesn't want to deal with the entire payout, but she wants the chance to earn more on the $500,000 than installment payments would provide. She decides to go the annuity route, allowing the insurance company to take the entire $500,000 and invest it long term. In return, the insurance company provides Laura with a monthly stream of income that may last the rest of her life. Laura gets to choose the annuity term (how long the monthly payments will last) and whether she wants a fixed, variable, or indexed rate of return.

Pros of life insurance annuity payout

For some beneficiaries, a life insurance annuity payout is the ideal solution. Here are some of the circumstances under which this option may make sense.

Less tempting

Let's say Laura is softhearted and has trouble saying no. Laura's extended family knows that and takes advantage of her kindness by regularly asking for money. One pro of an annuity, in this case, is that Laura only receives $2,000 per month and is not so flush with cash that greedy relatives see her as the family bank.

Instant money management

Before his death, Bob took care of the finances, and Laura is unsure of where or how to begin investing. An annuity removes the guesswork.

Potential for guaranteed rate

If Laura opts for a fixed-rate annuity, she knows exactly what the rate of return will be on her investment, even if the market tanks.

Boosted security

If Laura decides she wants monthly payments for the rest of her life, she knows that she can depend on that income, no matter what happens to Social Security.

Cons of life insurance annuity payout

There is no financial product that's right for everyone. Here are some of the drawbacks of a life insurance annuity payout.

Complexity

A single annuity can be confusing to understand. When a person like Laura, who has little experience dealing with finances, is introduced to annuities, it can be a bit of a nightmare. That's because there are four different types, and even after she's chosen the one that appeals to her the most, there are a slew of other decisions to make regarding the annuity. For a person dealing with shock and grief, the complexity may be too much.

High fees

The most common complaint about annuities is how high the fees are compared to other financial products, like mutual funds. When purchased through an agent, there is a considerable upfront sales charge. Charges are likely to be lower through an insurer, but it pays to check before investing.

Less available cash

Let's say Bob and Laura still owe $175,000 on their mortgage and $50,000 on other bills when Bob dies. Placing the entire life insurance payout in an annuity means not having a lump sum to do things like getting out of debt.

How does life insurance work?

There are two basic types of life insurance, although there are many subcategories. There's term life insurance that, as the name suggests, lasts for a specific period and pays out only if the policyholder dies.

And then there's permanent life insurance, like whole or universal. These policies include a death benefit (the amount paid to beneficiaries following the policyholder's death) but may also include the opportunity to invest or build cash value.

For anyone looking to find out what life insurance covers, the answer is: The primary purpose of life insurance is to pay out upon the death of a policyholder, providing funds to their beneficiaries.

How do annuities work?

A person does not have to be the beneficiary of a life insurance policy to buy an annuity. Anyone can purchase an annuity, either by providing a lump sum of money or making regular payments. The funds are invested, and recurring payments are made to the annuitant (the person who owns the account). Payments can begin immediately or be deferred until the annuitant is older, whichever they prefer.

Life insurance vs. annuity

People sometimes ask, "Is an annuity life insurance?" The answer is no. Life insurance and annuities are similar in that they help prepare for an uncertain future, but there is a difference between life insurance and an annuity.

Life insurance and annuity similarities

Life insurance policies and annuities share a few similarities, including:

• Each is designed to protect the policyholder or account owner financially.
• Each can be purchased through an insurance company.
• Each involves estimating how much money will be required in the future.

Life insurance and annuity differences

There are also ways life insurance and annuities differ. For example:

• The younger a person is, the less expensive it is to purchase life insurance. The same is not true of annuities.
• As long as premiums are paid and there is a qualified death, life insurance pays out to the beneficiaries. On the other hand, beneficiaries only benefit from an annuity if the annuitant purchases an annuity that includes a death benefit.

Is life insurance or annuity better?

The purpose of a life insurance policy is to make sure beneficiaries are taken care of. The purpose of an annuity is to make sure a person does not outlive their income. They are two very different products with one thing in common: They both provide a financial cushion.

Unless a person is so well off that they know the money they leave behind will take care of their heirs and are wealthy enough to be confident they won't outlive their income, life insurance and annuities can be equally helpful.

Types of life insurance

Life insurance comes in different shapes and sizes. Here are five of the most common.

1. Term life

Policies are written for a specific number of years. Since there are no bells and whistles associated with a term life policy, premiums tend to be the most affordable. A death benefit is only paid if the policyholder dies while the policy is still in effect.

2. Whole life

Whole life insurance can be in effect throughout the remainder of a policyholder's life, as long as premiums are paid. Permanent life insurance policies like whole life cost much more than term life policies but build cash value that can be borrowed against. Policyholders are guaranteed a fixed rate of return.

3. Universal life

Like a whole life policy, universal life insurance builds cash value. The big difference is that there is no guaranteed rate of return on a universal life policy. One feature policyholders enjoy is the ability to adjust their monthly payments and death benefit to fit their budget.

4. Variable life

Variable life insurance is a type of whole life insurance. It remains in effect indefinitely, as long as premiums are paid. The rate of return on the cash value is variable, meaning there is no guarantee of how much a policyholder will earn. Variable life maybe best considered as a high-risk, high-reward policy.

5. Guarantee issue

Sometimes referred to as "final expense insurance," a guaranteed issue policy pays a low level of death benefits but is available without a medical exam, regardless of the applicant's health status. It frequently has a smaller death benefit and is intended to pay final expenses.

Types of annuities

As mentioned, once a person decides to purchase an annuity, they must determine which type best fits their circumstances. Here are the four types of annuities.

1. Immediate annuities

Once the money is contributed to an immediate annuity, payouts begin. The upside is that the annuitant knows precisely how much they will receive through each payout. Some insurers offer an optional death benefit that sends payments to beneficiaries upon the original account holder's death.

2. Deferred annuities

Deferred annuities are one way for a retiree to feel confident they'll have enough to get by each month. They may opt to receive annuity payments monthly or in lump sums. Depending on the investment type chosen, deferred annuities have growth potential. There are no contribution limits, and deferred annuities are tax-deferred, meaning the account holder does not pay taxes until they withdraw funds.

3. Fixed annuities

The interest rate on a fixed annuity is guaranteed for a specified time. While fixed annuities don't benefit from upswings in the market, they are not harmed by dips in the market either.

4. Variable annuity

With a variable annuity, investors put their money into subaccounts that rise or fall with the stock market. They also come with a death benefit and income rider that guarantees income to beneficiaries.

Whether a person is shopping for life insurance or an annuity, it is essential to ask questions. Work with an agent to learn more about how life insurance payouts work and when (and if) there is a life insurance tax. Spend time with a financial advisor to find out about investment strategies to minimize taxes and the best way to make sure there is enough money set aside to comfortably move through retirement.

The good news is that there are so many options for life insurance and annuities. The tricky bit is that it can take time to wade through options to figure out which is the best fit.