Annuities vs. Life Insurance: What’s the Difference?

Quick Answer

Annuities can help you create an additional income stream so you don’t outlive your retirement funds. By contrast, life insurance financially protects your beneficiaries and loved ones after your death.

Woman seated on the floor researching insurances.

Annuities and life insurance are similar in that both involve contracts between insurers and policyholders. Both can serve as investments that grow tax-deferred but come with expenses that can potentially offset some of your gains.

Both life insurance and annuities may be included in your long-term financial plans, but they're not the same. Understanding the critical differences between annuities and life insurance and how they work can help you create a roadmap that best addresses your needs.

What Is Life Insurance?

Life insurance provides financial support to your loved ones when you die. When you have an active life insurance policy, you'll make regular payments to maintain your policy. In return, the insurance company delivers a cash payout if you die during your policy's term. Your beneficiaries can receive this death benefit tax-free and use the funds to replace your income, pay bills or for another purpose.

Life insurance comes in two broad forms: term life and permanent life. Generally, term life insurance covers you for a specific time period, usually one to 30 years, and is less expensive than permanent coverage.

By contrast, permanent life insurance lasts for your lifetime as long as you pay your monthly premiums. Like term coverage, permanent insurance delivers a death benefit to your beneficiaries. Where permanent life insurance differs is that it allows you to build cash value over time. Your funds grow tax-deferred, and they can be used to supplement your retirement savings, pay for your child's college tuition or for other goals.

What Is an Annuity?

An annuity can provide you with an income stream while you're living. Typically, people purchase annuities to create a source of retirement income.

When you buy an annuity, you agree to pay your insurance company, typically through a lump sum or a series of payments. For their part, your insurer agrees to issue payments to you now or in the future.

When it comes to annuities, you have a few different options to choose from:

  • Fixed annuity: A fixed annuity may be the safest form of an annuity since your insurer typically provides a guaranteed return on your contributions. While the rate could fluctuate, your insurer usually provides a guaranteed minimum rate of return. Another option is a fixed index annuity, which ties your return to a stock market index. Because the market underpins your policy, your gains and losses are limited by stock performance.
  • Variable annuity: With a variable annuity, you choose investments called "subaccounts" which include stocks, bonds and money market accounts. Like a fixed index annuity, these subaccounts can change in value with the stock market. Variable annuities also come with a death benefit guaranteeing your beneficiaries will receive a specified amount if you die before your insurer starts issuing payments to you.
  • Income annuity: An income annuity converts all or part of your lump-sum contribution into a guaranteed stream of income. Your payments can begin almost immediately or at a later time, and they can continue for your entire life or last a specific number of years.

Perhaps the most valuable benefit annuities offer is the possibility of an income stream you won't outlive, which is particularly important in retirement. Your annuity payments can end after you die, or you can add a provision for a surviving spouse or another designated beneficiary to receive a death benefit. The amount your beneficiary receives may be the remainder of the money or a guaranteed minimum, whichever is greater.

Like other retirement vehicles, annuities often come with taxes and fees, including commission fees, surrender fees and early withdrawal penalties.

How Are Life Insurance and Annuities Different?

While life insurance provides a financial safety net for your loved ones when you die, annuities provide financial protection while you're living so you won't outlive your retirement funds and assets.

Here is a breakdown of the primary differences between life insurance and annuities:

Life Insurance vs. Annuity
Life Insurance Annuity
Pays upon your death Pays during your lifetime
Provides a tax-free death benefit to your beneficiaries when you die Provides taxable income for your lifetime (or potentially beneficiaries when you pass)
Payment issued upon the death of the insured Payments may stop upon the death of the policyholder, depending on your policy options
Provides death benefits automatically Death benefit rider is optional
Grows tax-deferred Grows tax-deferred

When Should You Consider Life Insurance?

Generally, life insurance is a good idea if other people depend on your income or you carry debt that will continue after you die (such as a mortgage). Since life insurance becomes more expensive as you age, you might consider purchasing life insurance to lock in a lower rate when you're younger.

Permanent life insurance offers fixed premiums, lifelong protection and the ability to grow cash value. However, permanent coverage is significantly more expensive than term insurance, and the rate of return is often low compared with other investment products. As a result, purchasing permanent life insurance might only be worth considering once you've already maxed out other retirement vehicles such as a 401(k) or IRA.

When Should You Consider Annuities?

If you're already maxing out your annual contributions to your retirement fund, adding annuity income to your retirement plan may make sense. If you have extra money to add to your retirement savings, you may benefit from an annuity's tax-deferred growth, particularly if you're currently in a high-income tax bracket.

Keep in mind that an annuity may incur fees higher than those for a 401(k) or another retirement product.

Create and Follow an Overall Retirement Plan

Life insurance and annuities can be valuable components of your overall retirement plan, but they're probably not the first place you should look when planning your investments for the future. If your employer offers a 401(k) or another retirement plan with an employer match of your contributions, consider starting there.

If your employer doesn't offer a retirement plan, you can open your own account. There are plenty of options that provide tax advantages and the opportunity for growth. Here are seven 401(k) and IRA options you might consider as alternatives, or supplements, to a workplace retirement plan:

Annuities and life insurance can play an essential role in your financial plan for the future and protect your income during your retirement years (annuities) and after your pass (permanent life insurance). As investments, however, cash value life insurance and annuities may underperform compared with other investments such as the stock market and traditional retirement plans. Consequently, it may be wise to max out your contributions to your employer's retirement plan or your own 401(k) or IRA before buying annuities or permanent life insurance.

The Bottom Line

If you're unsure if you should opt for life insurance or an annuity plan, consider the primary objective you want to achieve. An annuity might fit the bill if you want to add a new income stream to your retirement plan. But if you want to ensure your beneficiaries and other dependents are financially protected after you die, a life insurance policy could address your needs.

Having a solid financial profile is essential now and in your retirement years. Part of that profile involves your credit score, which can impact the rates you receive for insurance, credit cards, loans and other credit products. Some states allow insurers to use credit-based insurance scores when setting their rates. So before you apply for insurance, check your credit score and credit report for free with Experian to see where you stand.