Insurance companies create both annuities and life insurance. While both have features that resemble each other, their purpose is very different. Life insurance provides money when you die to pay for any remaining bills, cover the cost of the funeral, give money to loved ones or for any other financial obligation or desire you wish to fulfill even in death. Annuities provide tax-deferred savings for retirement.
Both annuities and life insurance offer a death benefit to a named beneficiary. However, that's where the comparison stops. If you pay $100 into an annuity and die, your beneficiary will receive $100 plus any interest that has accrued. If you pay a life insurance premium of $100, your beneficiary will receives the face amount of the policy, which could be hundreds of thousands of dollars. To protect people who are dependent on you in the event of your death, life insurance is best.
Some life insurance policies have a cash value. They are whole life policies, in contrast to term policies, which only provide insurance coverage. Whole life insurance and annuities both have savings aspects. However, life insurance policies accumulate funds more slowly because some of the money pays for the insurance cost. If your main goal is savings, buy annuities.
Taxation of Death Benefits
Both life insurance and annuities have tax benefits. No matter what kind of life insurance you select, the beneficiary receives the funds tax-free when you die. However, if you leave money in an annuity to a beneficiary, she will have to pay taxes on any growth (interest) on the money you put into the contract.
Both the cash value of life insurance and the value of an annuity grow tax-deferred. Since an annuity is a retirement vehicle, if you take out the funds before you reach age 59 1/2, you pay taxes and a 10 percent penalty on the interest, just as you would for an IRA. If you cash surrender a life insurance policy, you pay taxes on the interest but normally no penalties. The penalties occur only if you have a modified endowment contract.
You cannot borrow money from an annuity or use it as collateral. The same is not true of life insurance. You can do both. When you borrow money from the cash value of life insurance, as long as the contract remains in force, there's no tax. You can make payments if you like, pay interest only or allow the contract to pay its own interest through borrowing against remaining cash value if there's enough.
Both the annuity and the life insurance policy can be useful financial products. The best one is the one that fits your needs. If you need a death benefit, don't count on the annuity, unless you’re positive that you won't die for a long time. When saving for retirement, while life insurance offers a cash value, if you don't need the death benefit, you're better off with the annuity. However, compare the advantages and disadvantages of annuities with other investments before making a decision.