In the world of investing, most of the attention goes to stocks, bonds, and real estate, while vehicles such as annuities and life insurance get somewhat overlooked. These latter products, however, can be valuable, diversifying additions to your retirement portfolio and are worth considering. Let’s examine the differences and key advantages of both annuities and life insurance so you can make a well-informed decision about your financial growth.
What Is an Annuity?
An annuity is both a type of insurance product and a contract between you and an insurer. The general idea is that you pay into the annuity up to a particular amount and it grows tax-deferred for a specified term. The rate at which it grows depends on the type of annuity you’ve chosen. For example, a fixed annuity has a set interest rate that remains constant for the life of the contract, whereas a variable annuity has fluctuating rates that reflect market performance.
At the end of the contract term, you can choose to roll your annuity over into another product (for example, another annuity) or convert it into a series of cash payments (a process called annuitization). If you roll it over, you stand to grow your initial investment exponentially; if you annuitize, you get a reliable source of income that may last you the rest of your life, with each distribution being taxed as income.
An annuity is strictly a retirement product, however, so you’re subject to a tax penalty if you withdraw from the account before the age of 59.5. There are also penalties if you withdraw during the period of growth called the surrender period.
Advantages of Annuities for Retirement
Some of the key advantages that annuities offer are:
- Guaranteed retirement income: When you annuitize your contract, you’ll begin to receive regular cash distributions from the insurer. This supplemental income is valuable in retirement, when other income sources may be scarce.
- Guaranteed rate of return: With a fixed annuity, at least, you have the added security of a guaranteed rate of return. Knowing approximately how much you’ll get back in distributions also helps with retirement budgeting and planning.
- Tax-deferred growth: Because taxes don’t touch your contributions until you start making withdrawals, your annuity will grow with the full strength of compound interest.
What Is Life Insurance?
Life insurance, too, is an insurance product and contract. Its primary purpose is to provide your survivors with money after your passing. You pay a monthly premium, and should you pass away while the policy is in effect, the insurance company pays a lump-sum death benefit to those you’ve specified as your heirs.
There are two broad varieties of life insurance. Term life insurance is a temporary policy that expires after a certain number of years (usually 10 to 30) and doesn’t build cash value, but permanent life insurance lasts your entire life and does build cash value.
Permanent life insurance can function as an investment vehicle. Part of each premium payment goes toward the cash value. The money grows tax-deferred, like an annuity, and you can withdraw or borrow against it to cover expenses while you’re still alive.
Advantages of Life Insurance for Retirement
The advantages of using life insurance as an investment vehicle include:
- Flexible withdrawals: You can use the cash value funds as you wish, without the early withdrawal penalties that come with annuities.
- Tax-deferred growth: With permanent life insurance, the cash value remains unaffected by tax while it accumulates interest.
- Tax-free withdrawals: Your withdrawals are also tax-free to an extent. You can withdraw up to the amount you’ve paid into the policy without paying tax.
Annuities vs. Life Insurance: How They Differ
Though annuities and life insurance do have some common characteristics — primarily investment potential and tax-deferred growth — there are also some key points of difference between them:
- Primary purpose: With annuities, the primary purpose is investment. With permanent life insurance, it’s to support your survivors after you pass away; the cash value is an additional feature.
- Time of payout: An annuity begins to pay out after the contract ends and you annuitize it. Life insurance — though you can withdraw from the cash value — fully pays out upon your passing.
- Benefactors: You are the primary benefactor of your annuity, though you can include a spousal or survivor benefit. In contrast, your specified heirs are the benefactors of your life insurance policy.
- Liability to taxation: Withdrawals on your annuity are taxed as income. With life insurance, your cash value withdrawals aren’t necessarily taxable. The payout to your benefactors isn’t liable to taxation, either.
Annuities and life insurance can both be fruitful additions to an investment portfolio, but we recommend speaking with a financial adviser to determine whether one, the other, or both products are suitable for your particular retirement strategy. Consider your goals, means, and timeline carefully to make the best choice for your needs.
