What's the difference between an individual retirement account (IRA) and an annuity?
Individual Retirement Accounts (IRAs) and annuities both provide the opportunity to grow money on a tax-deferred basis, but there are differences between the two. An IRA can be thought of as an individual savings account with tax benefits. You open an IRA for yourself (that's why it's called an individual retirement account) and if you have a spouse, you'll have to open separate accounts. An important distinction to make is that an IRA is not an investment itself; rather, it is an account where you keep investments such as stocks, bonds and mutual funds. You get to choose the investments in the account, and can change the investments if you wish. Your return depends on the performance of the investments held in the IRA. An IRA continues to accumulate contributions and interest until you reach retirement age, meaning you could have an IRA for decades before making any withdrawals.
IRAs are defined and regulated by the IRS, which sets eligibility requirements, limits on how and when you can make contributions, take distributions, and determines the tax treatment for various the various types of IRAs. For example, for 2014 the maximum you can contribute to your traditional or Roth IRA is the smaller of $5,500 ($6,500 if you're age 50 or older) or your taxable income for the year. Traditional IRA regulations allow you to take early withdrawals under certain circumstances, and if you have a Roth, you can withdraw contributions at any time, but will pay a penalty if you withdraw any interest earnings.
Conversely, annuities are insurance products that provide a source of monthly, quarterly, annual or lump sum income during retirement. An annuity makes periodic payments for a certain amount of time, or until a specified event occurs (for example, the death of the person who receives the payments). Unlike an IRA, which can have only one owner, an annuity can be jointly owned. Annuities do not have the annual contribution limits and income restrictions that IRAs have.
You can “fund” an annuity all at once – known as a single premium – or you can pay over time. With an immediate annuity (also called an income annuity), fixed payments begin as soon as the investment is made. If you invest in a deferred annuity, the principal you invest grows for a specific period of time until you begin taking withdrawals – typically during retirement. Annuities typically have higher expenses than IRAs, and if you take early withdrawals you'll owe a penalty.
Night and Day. An IRA is a covered by Title 26 of the US Code of Federal Regulations which means that it is a type of Qualified account. When you set it up, you qualify for an income tax deduction (if you meet the thresholds) for your contribution, and the earnings grow tax-deferred. The intent is that the monies are to be used for your retirement in your 60's, so the IRA imposes an early surrender penalty of 10% + income taxers if you withdraw the monies before then.
An annuity is not a qualified account. You get no tax deduction for setting it up, but the earnings do grow tax deferred indefinitely. If you're under 59 1/2, you'll have to pay a 10% penalty to withdraw funds (in most cases) and the income is taxed as ordinary income.
It is sometimes confusing because some people can buy tax-deferred annuities inside of a tax-deferred IRA account. The IRA account is the "vehicle" and the annuity is the product or gasoline that runs the vehicle.
You are limited as to how much money you can put into an IRA account, but there is no limit to how much you can contribute to an annuity.
Annuities and IRAs are powerful financial planning tools. I have clients that have maxed out the total allowable 401(k) and IRA contributions ($53,000) and still have money left over. In this case, they'll purchase investment-grade annuities with low fees and expenses to grow their tax-deferred savings even more.
With an individual retirement account (IRA), you are in control of the investments and you have a greater number of investment choices available to you. You have unlimited upside potential, but you also have downside that can go to zero.
Annuities come in a variety of "flavors" with limited investment choices that are controlled by the issuing insurance company. Some offer guaranteed income for life, some offer death benefits or spousal income benefits. So your upside is limited but your downside is limited as well. Some annuities have high internal expenses so that they can offer their benefits, further reducing your upside.