Permanent life insurance policies and annuity contracts have entirely opposite objectives. Life insurance provides the beneficiary or beneficiaries with a lump-sum payment when the insured person dies, while annuities provide the investor with guaranteed lifetime income streams. Both products are often marketed for their tax-deferred benefits compared with traditional stock and bond investments. On the other hand, both insurance and annuities have high expenses that can reduce investment returns during the early years of the contract.

Life Insurance

There are several types of policies. The simplest and least expensive of all contracts is a basic term life insurance policy. In exchange for a small monthly payment, your beneficiaries receive an amount agreed upon by you and the insurer, provided you die within the agreed term.

A "permanent life" or "whole life" insurance policy, also called a cash value policy, adds a savings component. As a result, premiums tend to be higher than those for comparable term policies. With these policies, life insurance companies credit policyholders' cash accounts based on the performance of relatively conservative investment portfolios.

Another option is a variable life insurance policy, which allows policyholders to choose from a basket of stocks, bonds, and money market funds in which to invest. There is also a risk that those investments will perform poorly. Unlike regular investment or savings accounts, consumers do not pay taxes on investment gains until they withdraw funds. These policies also offer spending flexibility. For example, if your cash balance is high enough, you can take tax-free loans to pay for unexpected needs. The full death benefit remains intact as long as you repay the borrowed amount to the account, plus any accrued interest.

Special Considerations

One of the main drawbacks of using life insurance in your retirement strategy is administrative fees. As a result, it takes time for a policy's savings component to gain traction. In addition, when comparing providers, upfront fees, administrative fees, and agent commissions are often unclear.

Annuities

Annuities meet the needs of many people interested in investing part of their capital and receiving their principal plus earnings through periodic payments—monthly, every two months, semiannually, or annually—over a period of time. An annuity is a contract with an insurer. One type of annuity offers lifetime payouts. In either case, investors know they will have a financial cushion.

There are countless annuity products, including fixed annuities, which credit your account at a guaranteed rate. There are also variable annuities, whose returns are tied to a basket of stock and bond funds, and indexed annuities, with returns tied to a specific benchmark, such as the S&P 500 index.

Annuity Considerations

As with permanent life insurance policies, annuity products also require substantial upfront commissions that can erode long-term earnings. There are also "surrender charges," penalties investors must pay for withdrawing funds early or canceling the contract entirely.

Tax treatment can be a concern because, although earnings grow on a tax-deferred basis, if the owner withdraws funds before age 59½, any investment gains would be subject to ordinary capital gains taxes.

Qualified vs. Nonqualified Annuities

The annuities discussed above fall into the nonqualified category. Qualified annuity contracts are those held in IRAs or other tax-advantaged retirement plans, such as 401(k)s. A qualified annuity is funded with 'pretax dollars' and a nonqualified annuity with 'after-tax dollars', and they are subject to the same early withdrawal penalties and required minimum distribution (RMD) rules as other investments in qualified retirement plans.

References/Links

1. Internal Revenue Service.
   • Life Insurance and Disability Insurance Proceeds.
   • What's New—Estate and Gift Tax.
   • Publication 575 (2020), Pension and Annuity Income.
   • Topic No. 410, Pensions and Annuities.
2. Congress.gov. "HR748—CARES Act."