Saving money for just-in-case and when-your-time’s-up scenarios is smart. Life insurance and annuity products will help you and your loved ones with each. Here’s the lowdown on what you need to know about both insurance products — so you know what’s right for you.
How they pay policyholders
These insurance products pay differently. Here’s what you need to know:
Life insurance payouts
With life insurance, a beneficiary can opt for the payment of the death benefit in one lump sum (or one single payment) or in a specific income payout, in which an interest-bearing account is set up to deliver monthly or annual payments to the beneficiary.1
A lump sum payment isn’t taxable; however, the interest is taxable. Another option, a retained asset account, accrues interest over time and allows for the beneficiary to access the proceeds by writing a check against the account’s balance.2
With an annuity, payments can stream in over time, which can help supplement a person’s retirement income. It’s guaranteed income for a set period of time.
In order to not be charged a premature distribution tax penalty, you must be at least 59.5 when you take out your money from a deferred annuity. Different annuities have different payout schedules. Be sure to consider your financial goals and an annuity’s timeframe of payout and fee structure. Note: Some deferred annuities cannot be liquidated for eight years or more without incurring a surrender penalty.
With an immediate annuity, distribution payments start soon after a single premium payment is made. With a deferred annuity, distribution payments start on a set date in the future. Immediate annuities (and annuitized payouts from deferred contracts) may be offered as fixed or variable payouts. Fixed payouts are predictable and guaranteed; variable payout amounts will fluctuate based on the investment amount, rate of return and expenses.
For your life insurance policy, you’ll want to select a beneficiary, a person or an entity (i.e., your business), to receive the death benefit when you die. You can choose more than one beneficiary and divide the proceeds among them as you see fit. Also, have a contingent beneficiary as backup, in case your primary beneficiary dies before you.3
For a non-qualified annuity, you can choose multiple beneficiaries and you can designate different percentages of the annuity to each one. (If you don’t name a beneficiary, it’s likely the annuity will go through probate, which could result in attorney and court fees.) You can also change a beneficiary as long as you’re not required to name an irrevocable beneficiary. If the beneficiary is a spouse, they can defer the taxes until they take the distributions. A non-spouse who inherits an annuity can either 1) pay the income tax on the lump sum payment, 2) stretch out taxation of the gains by taking lifetime payouts, or 3) take advantage of the five-year rule in which the beneficiary withdraws smaller amounts from the annuity during this time to avoid taking one lump sum payment in the fifth year, which could put them in a higher tax bracket.4
An insurance underwriter screens applications and calculates the risk of each applicant, determining an appropriate premium for life insurance coverage.5
Annuities typically don’t require underwriting, making annuities with a death benefit rider a good option if an individual does not qualify for life insurance.
Most states allow insurance companies up to 30 days to review a claim. However, the payout process could take longer if the policyholder died less than two years after purchasing the insurance policy and fraud or misstated health information on the application is suspected.6
Your life insurance policy can fund a trust. The grantor (you) sets it up, it’s managed by a trustee, and the beneficiary benefits. The great thing about a trust is that it can lead to faster estate settlements and reduced tax burdens.7
There are two common types of life insurance trusts to choose between: an irrevocable (ILIT) trust and a revocable (RLIT) trust. You cannot change or cancel an ILIT once it’s set up. However, because an ILIT is not subject to estate taxes and claims from creditors, the beneficiaries tend to take home a larger inheritance. (Estate taxes apply only to large estates). On the other hand, a RLIT, aka a living trust, can be changed or cancelled. It only becomes irrevocable after you die or become incapacitated. A RLIT might be a better choice for growing families that will experience some changes along the way.7
Advantages to both
If you’ve maxed out your tax-advantaged retirement plans, such as a 401(k) or IRA, a deferred annuity can be a good option to help finance your retirement years. Also, you might feel more secure knowing you can count on some guaranteed income from an annuity, during your golden years.
Special circumstances allow you to use your own life insurance policy to your advantage. Called living benefits, life insurance riders let you access your own death benefit during your lifetime if you need long-term care or help with expenses and care related to a terminal (or critical) illness.8