With so many financial products on the market, it can be overwhelming for clients to understand which one might be best for them. Life insurance and annuities are two products that can serve as a good foundation for many financial planning strategies. While they may seem like opposites, there is some overlap in their benefits. 

Generally, life insurance functions as an estate planning tool and benefits heirs after the insured dies, while annuities provide a stream of income while the policyholder is alive. However, life insurance can provide living benefits in the form of cash value, and annuities can sometimes offer a death benefit. 

This article can be a great resource to share with your clients. It can help them understand the difference between the two products and determine the best option.

Annuities: Cultivating income

An annuity is designed to provide a steady income stream over a specified period, usually during retirement, but can be utilized at any age. Whether funded by a lump sum or periodic payments, annuities offer a range of growth options, from fixed interest rates to investment in mutual funds. This growth period culminates in a phase where the policyholder can begin receiving income payments.

Moreover, annuities can be structured to include a death benefit through optional riders, ensuring that any remaining balance is passed on to heirs according to the terms of the contract.

Types of annuities

Deferred annuities

In a deferred annuity, the insurance company agrees to provide an income stream at a future date, typically during retirement. Unlike immediate annuities, which begin making payments shortly after the initial investment, deferred annuities have an accumulation phase where the invested funds grow tax-deferred until the annuitant starts receiving payments. 

Deferred annuities offer flexibility regarding when income payments begin and can provide a reliable source of retirement income while offering the potential for investment growth depending on the annuity's underlying investment options.

Immediate annuities

With a single premium immediate annuity (SPIA), the insurance company provides an income stream immediately or shortly after an initial lump sum contribution is made. A SPIA generates a guaranteed income stream for as long as the annuitant wants.  A life-only SPIA provides income for as long as the annuitant is alive, while a period-certain SPIA provides income for a predetermined time. If the annuitant predeceases the period-certain duration, the remaining payments are received by a named beneficiary. 

Fixed annuities

In a fixed annuity, the interest rate applied to the annuity is predetermined by the insurance company. It remains constant for a set period, offering stability and security for the annuitant's investment. Fixed annuities are known for their principal protection, as they typically guarantee the return of the initial investment regardless of market fluctuations, making them a popular choice for individuals seeking a steady and reliable source of retirement income with minimal risk.

Variable annuities

A variable annuity offers several investment options through subaccounts, like mutual funds, stocks, or bonds. Unlike fixed annuities, the return on a variable annuity is not guaranteed and fluctuates based on the performance of the underlying investment options the annuitant chooses. Variable annuities can offer higher returns than fixed annuities, but they also come with greater investment risk, as the value of the annuity can decrease depending on market performance. Variable annuities often offer optional features such as death benefits or living benefits, but these features may come with additional fees and expenses.

Life insurance: Safeguarding legacies

In contrast, life insurance offers a predetermined death benefit upon the insured’s passing. While term life insurance provides straightforward coverage for a specified period, permanent life insurance policies offer a dual benefit of lifelong coverage and cash value accumulation.

Through cash value growth, permanent life insurance policies enable policyholders to build a reserve that can be tapped into during their lifetime. Additionally, the death benefit provided by life insurance policies offers heirs a tax-free inheritance, ensuring their financial security.

Types of life insurance 

Term

Term policies offer coverage for a specific period, typically 10 to 30 years, during which the insured pays a fixed premium. If the insured dies within the policy term, the carrier pays a death benefit to the beneficiaries named in the policy. Term policies don’t accumulate cash value like permanent life insurance policies; instead, they offer pure death benefit protection at a more affordable cost. It is renewable at the end of the term, typically at higher premiums based on the insured's age and health status at the time of renewal. Term policies can also be converted to permanent policies without evidence of insurability. The products available for conversion are at the carrier's sole discretion.  

Permanent

Permanent policies cover the insured's entire lifetime as long as premiums are paid. Unlike term life insurance, permanent policies accumulate cash value on a tax-deferred basis, and the policyholder can access the funds income tax-free via withdrawals or loans. An additional benefit of permanent policies is that the insured may be able to adjust their coverage amount or premium payments, making them a popular choice for individuals seeking insurance protection and long-term financial planning.

Underwriting 

When considering underwriting requirements, both annuities and life insurance present distinct considerations. Life insurance typically necessitates health and financial underwriting, making it more favorable for those in good health and at a younger age. However, there are exceptions, such as guaranteed whole life insurance. Therefore, if a client has impaired risks, they can still consider life insurance for their estate planning needs.

In contrast, annuities offer guaranteed qualifications, making them accessible to individuals regardless of their health status. However, financial underwriting questions and minimum and maximum age requirements may still exist. In addition, certain annuities, such as a SPIA, can require some medical underwriting if they are rated products, meaning the insurance company assigns a rating to the annuitant based on their health status or other risk factors. If the annuitant has certain health conditions or other factors affecting life expectancy, the insurance company may adjust the payout amount accordingly.

Benefits

Regarding benefits, life insurance creates a robust inheritance for heirs, with the potential for substantial growth of premiums into a more considerable death benefit. Furthermore, life insurance's tax advantages, including tax-free withdrawals of premiums and the ability to borrow against cash value, enhance its appeal as a long-term financial tool.

Conversely, annuities offer investment and income benefits during the policyholder's lifetime, with the potential for higher returns and various income options available. However, early access to funds may be restricted, with potential surrender fees and tax implications for withdrawals before a certain age, typically before 59.5.

Tax treatment

Life insurance offers greater flexibility for accessing funds early, particularly before retirement. Once the policy accumulates cash value, the policyholder can withdraw or borrow against it as needed, without any age restrictions.

On the other hand, annuities require a commitment to keep the funds invested for a specified period. Some annuities may permit penalty-free withdrawals up to a specific limit, typically around 10%. However, If the annuitant opts for a large lump sum withdrawal or terminates the contract prematurely, the insurance company may levy a significant surrender fee. 

As mentioned above, if the annuitant is under 59.5, the IRS may impose a 10% early withdrawal penalty in addition to income tax that must be paid on the gains.

Due to these potential taxes and penalties, annuities are most effective as long-term retirement planning tools.

Converting life insurance into an annuity

A permanent life insurance policy can be converted into an annuity through a 1035 exchange, which allows for the tax-free exchange of one insurance policy or annuity contract for another.

In this scenario, the cash value accumulated in a permanent policy can be transferred directly to an annuity contract without triggering immediate taxation on the gains. The annuity will then provide income based on the funds transferred from the life insurance policy. However, policyholders must remember that they will lose their death benefit and must consider the terms, fees, and features of the life insurance policy and the annuity before initiating the exchange, as it may have implications for tax treatment, liquidity, and investment strategy. 

Which option is best?

Clients don’t necessarily need to choose between the two. Someone can simultaneously have a life insurance policy and an annuity to form a comprehensive financial plan.

Individuals may choose to have a life insurance policy and an annuity to address different financial needs at different stages of life. For example, someone may have a term life insurance policy to cover temporary financial obligations, such as to provide income replacement for dependents in case of death, and an annuity to provide a steady income stream during retirement.

Additionally, an individual may choose a permanent life insurance policy to access the cash value before retirement and use an annuity to supplement income once they reach retirement age.

Ultimately, the decision to have a life insurance policy, an annuity, or both depends on personal financial goals and risk tolerance. It's essential to carefully consider the features and benefits of each product and consult with a financial advisor to develop a comprehensive financial plan that meets specific needs and objectives.

Next steps

A tech-enabled brokerage like Modern Life can help your clients find the best coverage available, whether it’s through life insurance, an annuity, or both. With advanced digital underwriting capabilities, our platform makes the entire process, from onboarding to quoting to application, as easy as possible. To learn more, fill out the form below.