Life Insurance vs. Annuity: What is Right for You?

Life insurance and annuities can both be used to help fund retirement, but they work very differently.

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Updated May 13, 2024
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When planning for your future, it's important to have the right financial protections in place. Generally, you'll want to make sure you have money to last you throughout your life and help ensure your family is cared for after you pass away.

Both life insurance and annuities can help you accomplish these goals, but they work very differently. Before you move forward with one or the other, it's important to understand the difference between life insurance vs. annuity products. Here's how they’re different, plus the pros and cons of each.

In this article

Life insurance vs. annuity: The basics

Life insurance and annuities are both insurance products, which require you to pay premiums in exchange for benefits. However, they work very differently.

Life insurance is typically intended to protect your loved ones in the event of your death. However, whole life insurance policies could also provide a source of income since they have an investment component. But just like any other investment, returns aren’t guaranteed.

If you pass away for a covered reason, your life insurance will generally pay a death benefit to your loved ones, which they’ll likely receive tax-free. You can choose the death benefit you'd like to provide when you apply for coverage, with higher death benefits resulting in higher insurance premiums.

On the other hand, annuities are primarily intended to provide you with guaranteed income for a period of time, generally in retirement, which can make them useful for retirement planning. While some annuities offer a death benefit, that benefit is typically equal to either the unused money left in the annuity or to a set percentage of the initial premium paid. And part of the payout may be considered taxable by the IRS.

How does life insurance work?

Life insurance is an important form of protection because it can help protect your loved ones from suffering financial loss after you are gone. Chances are good you have people who depend on your income. Life insurance can provide a lump sum payout to help replace your lost earnings or to hire someone to help your family with things like childcare in the event of your death.

There are several different types of life insurance, but policies can be broadly divided into two types:

  • Term life insurance: Term life insurance is in effect for a limited period of time — the term of coverage. If you die for a covered reason during the term, the death benefit is paid out. If you don't die, no benefits are paid. Premiums are typically low, and the policy doesn't acquire any cash value.
  • Whole life insurance: Whole life insurance works differently. It’s intended to remain in effect indefinitely, so no matter when you pass away, your beneficiaries could receive a death benefit (as long as you remain current on premiums). Whole life insurance premiums are typically more expensive than term life premiums, and some of the money you pay is invested. The investment portion of your policy could acquire a cash value that you can borrow against or withdraw, assuming market conditions and other factors work in your favor. There are different kinds of whole or permanent life insurance, including traditional, variable, universal, and variable universal. The differences relate to how money is invested and how flexible your policy is.

Whichever life insurance product you choose, your death benefit will typically be determined when you apply for the policy. For example, if you apply for a $1 million term or whole life policy, your life insurance beneficiary will receive $1 million if you die from a covered cause while your policy is in effect. This is true even if you have been paying premiums only for a short time and haven't paid in $1 million in premiums yet.

However, certain insurers, like Ladder, may let you increase or decrease your coverage. This flexibility can be useful for different stages of your life. Read our Ladder review for more information.

Pros and cons of life insurance

There are some big advantages — and some big disadvantages — of life insurance for potential policyholders to consider.

The biggest benefits include the following:

  • Term life policies provide very affordable protection, with many people able to get covered for just a few dollars a month.
  • Whole life policies can make it easy to invest since you make one monthly premium payment that could help you build your cash value and provide protection for loved ones.
  • Death benefits are likely to be paid out income tax-free from both term life and whole life insurance.

But there are also some downsides to consider as well:

  • Term life policies might not result in a payout, so you could pay premiums for years and never get any benefits back.
  • Whole life policies are generally expensive, and there are often surrender fees and restrictions on when and how you can access your policy’s cash value.
  • Whole life policies might not provide as generous a return on investment as other investment options, while term life policies don't have an investment component at all.

How does an annuity work?

Annuities are insurance products because you pay premiums in exchange for a guarantee of shared risk. However, they have an investment component. They are often used to provide a guaranteed source of retirement income.

When you purchase an annuity, you either make a lump-sum payment or a series of payments. In exchange for your payment(s), you enter into a contract with the insurance company. The insurer guarantees that you will receive payments in the future. Depending on the type of annuity, you could be guaranteed payments for a fixed period of time, such as for 20 years or the rest of your life. Or you could receive a guaranteed lump-sum payout.

There are two phases or stages of an annuity. The first is the "accumulation phase,” in which you are making payments to the insurer. The second phase is the "payout phase,” when the insurer pays you. Here's how each of these phases works:

  • The accumulation phase: During this period, you're paying premiums to the insurer. The payments you make are invested into various assets, which could include interest-bearing accounts.
  • The payout phase: This is the second phase of an annuity, and it occurs when the insurance company begins making payouts to you. During the payout phase, you could receive a lump-sum payment or a steady stream of monthly payments. The money coming to you will include the premiums the insurer is returning, as well as any potential investment gains.

There are also different kinds of annuities, including the following:

  • Fixed annuities: Insurers promise a guaranteed minimum rate of return and guaranteed fixed payments for a pre-agreed period of time.
  • Variable annuities: Insurers allow you to choose what your annuity payments are invested in among a specific set of investments (which are usually mutual funds). The specific amount of money your annuity pays out to you will vary depending on the performance of your investments, your expenses, and the amount you invested.
  • Indexed annuity: With indexed annuities, your insurer promises you will receive a rate of return equal to a specific stock market index. For example, your rate may be linked to the S&P 500, so you'll be promised returns on par with the S&P's performance.

When you invest in an annuity, you will not pay taxes on either income from the annuity or any gains on your investments until you take money out. And if you die, a death benefit that includes any remaining annuity payments may be paid out to your chosen beneficiary.

Pros and cons of annuities

As with life insurance, there are some advantages and disadvantages of annuities.

Here are some of the biggest benefits:

  • Annuities are tax-deferred, so you won’t need to pay income taxes until you make withdrawals.
  • You can "insure your retirement" by buying an annuity that provides guaranteed income.
  • Guaranteed returns can provide protection from market volatility.

And here are some of the biggest disadvantages:

  • Some annuities come with high fees, especially if you withdraw money early.
  • You'll typically be limited in when and how you can access your money.
  • Other investments could potentially provide a better return.
  • You'll be taxed on withdrawals as ordinary income, while some other investments allow you to be taxed at the capital gains tax rate (which is typically lower for most people).

Life insurance vs. annuity: How to decide which is right for you

When deciding if life insurance or an annuity is right for you, it's important to consider your goals, preferred cost structure, and payout structure.

When a life insurance policy might be the better option

A life insurance policy may be the better choice in a few key circumstances. You should likely purchase life insurance instead of an annuity if:

  • You want to help protect your loved ones after you pass away. Annuities aren't designed to pay a death benefit to beneficiaries. However, this can happen if there's money in the annuity when you die or if your annuity contract provides for a set death benefit. And while life insurance death benefits are likely to be paid out tax-free, some portion of an annuity death benefit could be taxed if the money distributed includes investment gains.
  • You're OK with paying premiums indefinitely in order to get ongoing insurance benefits. Some whole life policies allow you to use your investment returns to pay premiums, but most people pay for these policies month after month indefinitely.

It's important to note that term life policies won't provide any money unless and until you pass away so they aren't a good choice if you're looking for a source of retirement savings.

And while whole life policies can provide some money for retirement, they generally don’t provide a steady income stream. With whole life policies, you can access your invested funds by surrendering your policy (that means giving up the insurance and usually paying fees), withdrawing up to the allowable amount (which might reduce your death benefit), or taking a loan against your policy.

When an annuity might be the better option

On the other hand, you should likely opt for an annuity instead of life insurance if:

  • You want a guaranteed source of income. Life insurance policies aren't designed to provide guaranteed income. While you may be able to borrow against the value of a whole life policy or make withdrawals from it, there's no guarantee of a steady stream of income until you die. Annuities can provide this, depending on what type of annuity you choose.
  • You don't want to pay insurance premiums forever. With an annuity, you may make a single lump-sum payment or make periodic payments for a set period of time during your accumulation phase. But once you enter into your payout phase, you no longer make payments but instead receive a regular monthly income.

Remember, though, with an annuity you may receive a lump-sum payment at a set time or may receive a regular stream of payments for a guaranteed period of time. These regular payments often come on a monthly basis, providing regular income during retirement. But your annuity may not provide a large death benefit, or any death benefit at all, depending on how the insurance contract is structured.


Is an annuity better than life insurance?

An annuity is not necessarily better or worse than a life insurance policy. The better option depends on your goals. Annuities can provide a guaranteed source of income during your lifetime, while life insurance policies can provide a guaranteed payout after your death.

What's the difference between life insurance and an annuity?

Annuities are designed to provide income during your lifetime. Although some annuities offer a death benefit, this death benefit may be based on a percentage of the initial principal or the remaining balance left in the annuity. In some cases, the death benefit might also be partially taxable.

On the other hand, life insurance is intended to provide a payout upon your death during your coverage term. Although some life insurance policies offer an investment component, these policies are primarily designed to provide for loved ones upon your passing. Death benefits aren’t taxable when paid by a life insurance policy.

What are the benefits of annuities?

Annuities can provide guaranteed income and tax-free investment gains during your accumulation phase. There are many different types of annuities, so you can choose between one that provides guaranteed returns, ties your returns to a financial index, or provides returns based on investment performance.

What are the benefits of life insurance?

Life insurance can be an affordable way to provide protection for loved ones. Term life policies are inexpensive and can provide a substantial death benefit if you pass away during a specific period. Whole life policies can provide a lifetime death benefit as long as you continue paying premiums and can also be used as an investment vehicle, with some whole life policies providing guaranteed returns.

Bottom line

Both life insurance and annuities can be good investments for those interested in lifetime income or protection for loved ones. It's important to consider your personal financial situation and goals when deciding which of the two to purchase. There are big differences between an annuity vs. whole life insurance or term life insurance.

Whatever you decide, make sure you've researched options carefully. And because costs and fees can vary, be sure to shop around and get quotes from the best life insurance companies or annuity providers. Companies like Bestow make it easy to get insurance quotes and apply for your policy entirely online with no medical exam or hassle. Read our full Bestow life insurance review for more information.

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Author Details

Christy Rakoczy

Christy Rakoczy has a Juris Doctorate from UCLA Law School with a focus in Business Law, and a Certificate in Business Marketing with an English Degree from The University of Rochester. As a full-time personal finance writer, she writes about all things money-related but her special areas of focus are credit cards, personal loans, student loans, mortgages, smart debt payoff strategies, and retirement and Social Security. Her work has been featured by USA Today, MSN Money, CNN Money and more, and you can learn more at her LinkedIn profile.