Simply put, the difference between variable annuities and whole life insurance is a matter of life and death. Annuities protect your retirement income, and life insurance protects your beneficiaries. Except sometimes annuities can protect beneficiaries and whole life insurance can be used for retirement income.
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What Are Variable Annuities?
Variable annuities protect investors from outliving their income. With an annuity, the policyholder (or annuitant) receives regular guaranteed income for life, or an agreed-upon number of years. Your annuity contract begins when you make a single payment or a series of payments.
- Deferred variable annuities accumulate money for a period of time before the policy pays income. Deferred variable annuities accumulate money in investments selected by the owner ,called subaccounts. Like mutual funds or other investments, the value of the subaccounts is based on market performance. They’re not guaranteed. Unlike mutual funds, subaccount capital gains and dividends are tax-deferred.
- Immediate variable annuities pay income right away.
- Indexed variable annuities offer partial protection from market losses and accumulate money by tracking a market index like the S&P 500.
- Qualified variable annuities are part of a pension plan or IRA. They are purchased with before-tax dollars.
- Non-qualified annuities are personally owned and paid for with after-tax dollars.
What Is Whole Life Insurance?
In exchange for a premium, the insurance company agrees to pay a benefit if the insured dies.
- Proceeds are usually paid to a named beneficiary.
- Proceeds are income tax-free to the beneficiary.
Whole life insurance is designed to protect beneficiaries from economic loss. It's used to:
- Protect families from loss of income
- Provide funds for specific purposes (i.e., education, special needs)
- Provide funds for final expenses
- Provide funds for legacy and charitable planning
Whole life insurance has a fixed premium for a set number of years. It's called whole life because it's designed to stay in force for the insured's entire life. Term insurance is designed only to stay in force for a set number of years.
Over time, whole life insurance builds cash value that may be used for emergencies, income, or anything else. The cash value is tax-deferred.
Life insurance companies also offer a disability waiver of premium for an additional fee. If the insured is disabled, the insurance company will pay the premium, and the policy will continue to build value.
Some whole life policies offer investment choices that are similar to variable annuities.
Retirement Planning with Whole Life Insurance
The differences seem pretty clear, don't they? Variable annuities protect your retirement income and life insurance protects your family or other beneficiaries. Well, as usual with financial products, there's more to the story.
If you are between 30 and 50, in good health, and you need life insurance, whole life can also be a source of tax-free retirement income.
Whole life cash values can be withdrawn up to the amount of premiums paid, income tax-free. Any additional withdrawals will be fully taxable at ordinary tax rates. Distributions taken as loans, however, are not taxable.
If the whole life insurance policy is properly structured it can provide tax-free retirement income using a combination of withdrawals and loans.
Sometimes using whole life insurance for retirement income is presented as a "7702 Plan." 7702 refers to the section of the tax code that defines life insurance. A "7702 Plan" is a marketing name for whole life insurance, nothing more.
Retirement Income from Life Insurance: Pros and Cons
On the pro side, life insurance has some unique features in addition to tax-free income. Whole life insurance offers a disability waiver of premium rider. This rider pays the premium in the event you are disabled and unable to work.
The rider protects your retirement savings from disability. Whole life insurance pays an income tax-free benefit in the event of premature death, creating the wealth for your beneficiaries that you would have saved for retirement.
On the con side, unless you need the life insurance death benefit, whole life is not a good alternative for retirement savings. If you are older than 50 or not in good health, whole life can be a useful planning tool for protection, but generally not for retirement income.
Legacy Planning with Variable Annuities
Variable annuities offer riders that use a benefit base to enhance the death benefit. For most death benefit riders, the benefit base starts out at the purchase payment. It increases by the higher of the account value or a percentage of the previous benefit base.
A variable annuity death benefit rider is way to accumulate wealth and protect beneficiaries from volatile markets. Variable annuity death benefit options come at a cost, usually as a percentage of the current death benefit.
A variable annuity death benefit that is guaranteed to increase can be attractive to investors who are in ill health, or otherwise cannot get life insurance. Variable annuity death benefits are not income tax-free and are not a substitute for life insurance.
Still, they can be a valuable planning tool under some circumstances.
Converting Life Insurance to a Variable Annuity
A tax-free transaction, known as a 1035 Exchange, is available to exchange life insurance for a variable annuity. What this means is that when the life insurance is liquidated to buy an annuity, no tax is due. The annuity distribution rules will apply going forward.
Life insurance is a valuable benefit, especially if the policy has been in force for many years. Review your insurance needs and any surrender penalties before exchanging life insurance for an annuity.
A 1035 transaction has to follow IRS rules to qualify for the tax benefit. An independent insurance agent can help you decide if converting your life insurance to a variable annuity is right for you. Consult your professional adviser for tax or legal advice.
Converting an Annuity to Life Insurance
There is no tax-free exchange to convert an annuity to life insurance. There are some circumstances when converting an annuity to life insurance may be a good planning strategy, but usually the transaction does not make good financial sense.
Supplemental Retirement Savings Variable Annuity or Whole Life?
If you have maxed out your 401(k), IRA, or other retirement savings plan, you may be looking for additional options. Variable annuities accumulate tax-deferred, and can provide retirement income guaranteed for life.
Whole life offers death benefit protection, tax-deferred growth, and potentially tax-free income. Both are long-term savings plans.
Variable annuities and whole life insurance are flexible financial planning tools. They can also be complicated and confusing, and they're not for everyone. Independent insurance agents are experts. They can explain the options and help you decide what's right for you.
TrustedChoice.com Article | Reviewed by Neel Lane
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