If you are new to investing and are trying to figure out how and where to place your hard-earned money, chances are that you have come across terms like “annuity” and “life insurance.” Both can really play significant roles in your financial plans. But you need to understand the differences between them, as this will help you make educated decisions and help you understand both the benefits and risk involved in financial planning.
This understanding will help you figure out your exact needs and save you from paying for what you don’t need. An annuity contract and a life insurance policy are both insurance products—and that’s what makes them similar. But the primary difference between them lies in when payment is made.
While an annuity contract pays a specified amount on a monthly, quarterly, or annual basis to meet future financial needs (usually in retirement), life insurance pays the value of the policy at the time of your death. Now, let’s discuss each of them in more detail.
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What is an Annuity Contract?
An annuity contract is a financial contract in which an insurance company pays you at regular intervals (monthly, quarterly, or yearly) in return for one or more premiums that you have paid. Most of the time, annuities are bought for future retirement income. So, with an annuity, you practically continue to earn a monthly or quarterly pay after retirement. Only an annuity can pay an income that can be guaranteed to last as long as you live.
However, you must bear in mind that an annuity is not a life insurance policy. It’s not a health insurance policy. It’s not a savings account or a savings certificate. And it is not a contract you can buy in order to reach short-term financial goals. Your value in an annuity contract is the amount you have paid in premiums, plus any interest your premiums have earned, minus applicable charges. There are two ways to pay your premiums:
You can pay in either one payment for a single premium annuity. For example, you can wait until you retire and then move a lump sum from your pension plan to an annuity in order to collect monthly payments from it. This would be considered a single premium annuity.
You can also pay in a series of payments for a multiple premium annuity. For example, if you decide at a young age to start saving for retirement, you might choose to purchase an annuity and make smaller monthly payments of $250 into the plan over a period of 30 years. This is a good example of a multiple premium annuity. Payments for a multiple premium annuity can be made either at fixed intervals (monthly, weekly, etc) or in flexible payments, allowing you to pay as much premium as you want within set limits.
Types of Annuity Contract
There are two types of annuity:
- Immediate Annuity
- Deferred Annuity
An immediate annuity starts to pay within one year of premium payment, though most actually begin payment within one or two months of receiving a premium payment. For this reason, immediate annuities must be purchased using a large lump sum single premium. You cannot purchase an immediate annuity with multiple premiums.
A deferred annuity delays payment until a later date as specified in your annuity contract. This could be 10 years, 20 years, or more. You can purchase a deferred annuity with either a single lump sum premium payment or multiple premium payments.
What is a Life Insurance Policy?
A life insurance policy is a contract you enter into with a life insurance company, but the focus is to provide a death benefit to your beneficiaries once you die. Death benefits are typically tax-free in many parts of the world. The purpose of a life insurance policy is to allow your beneficiaries to maintain their same standard of living or pay off large expenses.
Types of Life Insurance Policy
Life insurance contracts may be whole life or term life. A whole life insurance policy pays the face value of the policy to your beneficiaries at the time of your death based on premiums you have paid over the years. The premium may be paid as a single lump sum (single premium whole life insurance) or over a period (such as 10, 20, or 30 years).
Term life insurance has a face value from the time of purchase to the end of a specified duration, such as 5, 10, or 20 years. After this duration, the policy expires and has no value.