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The Fundamental Difference: Opposite Ends of Longevity Risk
Life insurance and annuities are mirror images of each other. Both are issued by insurance companies, both built around mortality, but designed to solve opposite problems. Life insurance pays out when you die too soon, protecting the people who depend on your income. An annuity pays out while you live, protecting you from running out of money if you live longer than expected.
Think of it this way: life insurance is income replacement for your survivors, while an annuity is income replacement for your future self.
| Life Insurance | Annuity | |
|---|---|---|
| Core Purpose | Protect dependents if you die prematurely | Provide income if you live longer than expected |
| Who Benefits | Your beneficiaries | You (the policyholder) |
| Payout Trigger | Your death | Your retirement / longevity |
| Medical Exam Required | Usually yes | No |
| Tax on Payout | Death benefit is income tax-free | Distributions taxed as ordinary income |
| Liquidity | Cash value (permanent policies) accessible via loans | Limited, surrender charges may apply |
| Typical Buyer | Working adults with dependents | Pre-retirees and retirees |
Both products share one important trait: tax-deferred growth. But how they get taxed at payout, and who receives the money, is fundamentally different. According to LIMRA's final 2025 data, total U.S. annuity sales increased 7% to $464.1 billion in 2025, with fourth-quarter sales jumping 14% to $117.2 billion, the ninth consecutive quarter of $100+ billion in sales. That is a clear sign that more Americans are using annuities to address longevity risk.
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Types of Annuities: Fixed, Variable, and Indexed
Not all annuities are the same. The three main types differ in how your money grows, how much risk you take on, and how much income you can expect. Choosing well matters more than ever in 2026, when product innovation and rate competition are reshaping the market.
Fixed Annuities and MYGAs
A fixed annuity guarantees a set interest rate for a defined period (think of it like a CD but with tax-deferred growth). Your principal is protected, your rate is locked in, and your future income is predictable. Multi-Year Guaranteed Annuities (MYGAs) are a popular fixed option, locking in competitive rates for 3 to 10 years.
As of June 2026, top MYGA rates reach 6.00% for a 3-year term, 6.45% for a 5-year term, 6.90% for a 7-year term, and as high as 7.65% for a 10-year term from carriers like Atlantic Coast Life and Mountain Life. From A-rated carriers specifically, the best fixed annuity rates range from roughly 5.00% to 5.60% depending on term length, with higher yields generally coming from B-rated regional insurers.
Variable Annuities
Variable annuities are tied to investment sub-accounts similar to mutual funds. Your returns go up or down with the market, meaning higher growth potential but also real downside risk. These are regulated by the SEC and FINRA in addition to state insurance rules. For full-year 2025, traditional variable annuity sales rose 8% year over year to $63.1 billion, reflecting renewed investor appetite for market-linked growth.
Fixed Indexed Annuities (FIAs) and RILAs
Indexed annuities are a hybrid: your principal is protected from market losses (a 0% floor), but your gains are linked to a market index like the S&P 500. Returns are capped or limited by a participation rate.
This category continues to dominate the market. For 2025, FIA sales reached $127.9 billion, the fifth consecutive year of annual sales growth for the product. Registered Index-Linked Annuities (RILAs) are the fastest-growing segment by far. RILA sales totaled $21.2 billion in the first quarter of 2026, a 21% year-over-year increase, marking the 30th consecutive quarter of growth, and LIMRA projects 2026 RILA sales to reach $85 billion, exceeding the record $79.6 billion set in 2025.
Converting Life Insurance to an Annuity: The 1035 Exchange
If you have a permanent life insurance policy with accumulated cash value that you no longer need for death benefit protection, perhaps your children are grown or your mortgage is paid off, you do not have to simply surrender the policy and pay taxes on all the gains.
Section 1035 of the Internal Revenue Code allows you to transfer the cash value of a life insurance policy directly into an annuity, tax-free. This can be a smart alternative to replacing a life insurance policy outright.
How a 1035 Exchange Works
- Evaluate your policy. Review your current cash value, your cost basis (premiums paid), and any embedded gains with a financial advisor.
- Choose your new annuity. Select an annuity product that fits your retirement income needs.
- Complete the 1035 exchange form. The new insurer provides this; the transfer must be direct (insurer to insurer). You cannot receive a check.
- Wait for processing. The process can take several weeks to a few months.
For a Section 1035 exchange to be tax-free, the transaction must be a direct exchange between insurance companies, with no constructive or actual receipt of funds by the policyholder. If the policyholder receives the proceeds of the old contract, even momentarily, before funding the new contract, the transaction is treated as a taxable distribution, not a tax-free exchange.
⚠️ The exchange must go from life insurance to an annuity only, not the other direction. You can exchange a life insurance policy for an annuity under the 1035 exchange rules, but the reverse is not true: you cannot exchange an annuity contract for a life insurance policy. The owner and annuitant must remain the same, or the IRS treats it as a taxable distribution.
Tax Benefits of a 1035 Exchange
| Scenario | Tax Treatment |
|---|---|
| Hold the new annuity | Continued tax-deferred growth on all gains |
| Annuitize for income | Exclusion ratio spreads taxes over your lifetime |
| Lump-sum withdrawals | LIFO rules apply, gains taxed first as ordinary income |
If all the surrender proceeds from the original policy are transferred into the new policy and there are no outstanding loans on the original policy, there will be no tax on the gain at the time of exchange. If the policy is surrendered without a 1035 exchange, the gain from the original life insurance contract will be taxed as ordinary income, not capital gains. This strategy is especially powerful if you plan to annuitize, since the exclusion ratio method allows each payment to be received partially tax-free. Learn more about how a policy review can help you decide when a 1035 exchange makes sense.
Tax Treatment, Combination Products & Who Benefits Most
Tax Treatment Side by Side
Both products offer tax-deferred growth, but their tax treatment at distribution is very different:
- Life insurance death benefits are generally received income tax-free by beneficiaries. Per IRS guidance, life insurance proceeds you receive as a beneficiary due to the death of the insured person are not includable in gross income and you do not have to report them. See our guide on whether life insurance is taxable for the exceptions.
- Life insurance cash value can be accessed through tax-free policy loans (if the policy does not lapse), making it a flexible source of retirement income. This is the foundation of the LIRP strategy.
- Annuity distributions are taxed as ordinary income on the earnings portion. If held inside a traditional IRA, every dollar withdrawn is fully taxable.
- Annuity death benefits passed to non-spouse beneficiaries are taxable as ordinary income, unlike life insurance.
Combination Products: Getting the Best of Both
Some insurers offer hybrid products that blend elements of life insurance and annuities into a single contract. These work by:
- Allocating premiums. A portion funds the death benefit, another portion builds an income stream.
- Using cash value. Permanent life insurance cash value can purchase or fund an annuity component.
- Adding riders. Annuities can add death benefit riders; life insurance can add income riders that function like an annuity.
These products are particularly well-suited for retirees who want guaranteed lifetime income and want to leave something behind for heirs. As a complement to life insurance as an investment, combination products can round out a holistic retirement plan.
Who Should Choose What?
Life insurance is the right choice if you:
- Have dependents who rely on your income
- Want to leave a tax-free inheritance for heirs, especially through estate planning strategies
- Are under age 60 and in good health (better rates)
- Need death benefit protection first and foremost
An annuity is the right choice if you:
- Are approaching or already in retirement
- Are concerned about outliving your savings
- Have maxed out your 401(k) and IRA contributions
- Want guaranteed income you cannot outlive
Both products make sense if you:
- Want income security in retirement and a legacy for your family
- Have a permanent policy with built-up cash value you would like to convert
- Are using a variable life insurance policy and want to shift toward guaranteed income as you age. Reviewing life insurance vs retirement accounts can also help clarify priorities.
Frequently Asked Questions
What is the main difference between life insurance and an annuity?
Life insurance pays a death benefit to your beneficiaries when you die, providing financial protection for those who depend on you. An annuity pays income to you while you are alive, protecting you from the risk of outliving your savings. Put simply, life insurance protects against dying too soon, while an annuity protects against living too long. Both products are issued by insurance companies and offer tax-deferred growth during the accumulation phase.
Can you convert a life insurance policy into an annuity without paying taxes?
Yes. Through a 1035 exchange under Section 1035 of the Internal Revenue Code, you can transfer the cash value of a permanent life insurance policy directly into an annuity without triggering a taxable event. The transfer must be made directly between insurance companies (you cannot receive the funds yourself), and the policy owner must remain the same. This strategy works well for people who no longer need the death benefit and want to convert their policy's value into guaranteed retirement income.
Which type of annuity is the safest?
Fixed annuities and MYGAs are generally considered the safest because they guarantee a set interest rate and fully protect your principal from market losses. As of mid-2026, top MYGAs from A-rated carriers are paying roughly 5.0% to 5.6%, with rates as high as 6.45% to 7.65% available from B-rated insurers. Fixed indexed annuities also protect principal with a 0% floor while offering some upside potential linked to a market index. Variable annuities carry the most risk since returns depend on market performance.
Are life insurance death benefits taxable?
In most cases, no. Life insurance death benefits are received income tax-free by beneficiaries, making life insurance one of the most tax-efficient ways to transfer wealth. However, if the death benefit earns interest after the insured's death (such as if the insurer holds the funds), that interest is taxable. Also, very large estates may be subject to estate tax depending on how the policy is owned.
Should I buy an annuity or life insurance first?
The answer depends on your life stage and financial situation. If you have dependents, debt, or anyone relying on your income, life insurance should generally come first, since it protects your family in the event of your death. As you approach retirement and your dependents become financially independent, shifting focus toward annuities to secure lifetime income becomes more important. Many financial planners recommend carrying both during the transition years, using life insurance for protection and annuities for guaranteed income.