Individual retirement accounts (IRAs) and annuities both provide tax-advantaged ways to save for retirement, but there are distinct differences between the two. For one thing, an IRA is not in itself an asset, it's a vehicle for holding financial assets—stocks, bonds, mutual funds. In contrast, annuities are assets—specifically insurance products, designed to generate income.
- Both IRAs and annuities offer a tax-advantaged way to save for retirement.
- An IRA is an account that holds retirement investments, while an annuity is an insurance product.
- Annuities typically have higher fees and expenses than IRAs but don’t have annual contribution limits.
- The tax treatment of your annuity payments depends on whether you bought the annuity with pre- or after-tax funds.
- Buying and holding an annuity within an IRA avoids any taxation of the annuity payouts.
- Buying and holding an annuity within an IRA makes redundant tax advantages of the annuity but doesn’t alleviate the annuity’s high fees and illiquidity.
An IRA can be thought of as an individual investment and savings account with tax benefits. You open an IRA for yourself (that's why it's called an individual retirement account). If you have a spouse, you'll have to open separate accounts (if one partner earns low or no wages, you can use the family income to open a spousal IRA, to benefit that spouse and double the family's retirement savings options).
An important distinction is that an IRA is not an investment itself. It is an account in which you keep investments such as stocks, bonds, and mutual funds. Within certain limitations, you get to choose the investments in the account and can change them 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 as well as limits on how and when you can make contributions and take distributions, and determines the tax treatment for the various types of IRAs.
There are two main types of IRAs—traditional and Roth. Contributions to traditional IRAs are made with pretax dollars and are deductible the year in which they are made. Withdrawals are taxed as income. Contributions to Roth IRAs are made with after-tax dollars, but withdrawals are not subject to tax.
Because of the SECURE Act, if you haven’t hit 70½ by the end of 2019, the required minimum distribution start date for most situations is not until age 72.
Traditional IRA account holders can start withdrawing funds at age 59½, although the IRS does allow you to take early withdrawals under certain circumstances. If you have a Roth, you can withdraw contributions at any time but will pay a penalty if you withdraw any interest or earnings from investments too early. The early withdrawal penalty for both types of IRAs is 10%.
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). Money invested in an annuity grows tax-deferred until it is withdrawn.
Unlike an IRA—which typically can have only one owner—an annuity can be jointly owned. Annuities also do not have the annual contribution limits and income restrictions that IRAs have.
There are a variety of annuities. You can “fund” an annuity all at once—known as a single premium—or you can pay into it over time.
With an immediate payment 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—usually during retirement. As with IRAs, you will be penalized if you try to withdraw funds from the deferred annuity early before the payout period begins.
Annuity Payments: Fixed or Variable
Both immediate and deferred annuities can dole out their payments at either a fixed or variable rate.
In a fixed annuity, the funds are managed by the financial entity. You have no say in how that money is invested. Once annuitization takes place, a fixed amount is paid to you—either as a lump sum or in payments over several years or your lifetime.
Variable annuities allow you to choose from a menu of investment options. These options could include mutual funds, bond funds, or money-market accounts. One version of a variable annuity, called an equity-indexed annuity, tracks a specific stock index such as the S&P 500. Obviously, opting for a variable rate holds out the possibility of greater returns; but it also carries greater risk.
A variable annuity is the most comparable to an IRA. Both are essentially tax-sheltered shells that house investment funds. However, variable annuities have higher annual expenses than IRAs do.
Because an annuity is basically an investment instrument inside an insurance policy, fees can be high. You pay fees for the insurance, management fees for the investments, fees if you try to get out of the contract (aka surrender charges), and fees for riders (optional additions to the basic contract, such as one that guarantees a minimum increase in annuity payments each year).
In contrast, an IRA usually carries at best a small custodial fee, charged by the financial institution where your account is held. Of course, mutual funds within the IRA charge their own annual management fees, called expense ratios.
Taxing Annuity Payments
One key question you’re probably asking now is: Are annuity payouts taxable? That depends largely on whether you purchased the annuity with pre-tax or after-tax funds—terms IRA investors know all too well. Essentially, the taxes you pay on an annuity distribution depend on the portion of that distribution that was not taxed initially.
Annuity payouts are taxed as ordinary income, not at the lower capital gains rate.
So, if you purchase the annuity with pre-tax money, such as funds from a traditional IRA, all payments are fully taxable. If you buy the annuity with after-tax money, you will not pay taxes on the return of your (already taxed) principal, but you will pay taxes on the earnings.
How you figure which is which can be a little complicated, involving something called the exclusion ratio, which divides your withdrawals over your life expectancy. Your accountant can do the math, or the annuity issuer might send you a year-end statement indicating the principal and earnings portions of the payout.
However, if you use funds from your Roth IRA or a Roth 401(k) to purchase an immediate fixed annuity when you retire, all payments will be tax-free because the source of those funds—your Roth IRA—is tax-free. (You’d still house the annuity within the Roth account.) However, the regular Roth distribution rules apply. You must be over age 59½, and you must have had the account for at least five years.
The same applies to holding a deferred annuity inside your Roth IRA.
Does an Annuity Belong in an IRA?
This, of course, leads to another question: Should your IRA be invested in an annuity?
As noted above, when you purchase an annuity inside an IRA, the IRS rules for the IRA supersede the rules for the annuity. This means that any detrimental tax treatment of the payments is irrelevant if the annuity resides inside the IRA. The advantage of a steady, guaranteed, tax-free income stream at retirement, however, might well justify putting a portion of your assets into such an annuity.
That’s from the payment standpoint. But from the investment-growth standpoint, things are a little murkier—especially if you’re relatively young (or at least decades from retirement) and buying a deferred annuity. In this case, you would be placing a tax-advantaged instrument (the annuity) inside a tax-sheltered account (the IRA)—which, on its face, doesn’t seem to make a lot of sense.
There’s also the issue of illiquidity. Most annuities carry heavy surrender charges if you decide you want to cash out and invest funds elsewhere. If your annuity is fixed, you have no say in deciding how those funds are invested. If your annuity is variable, the investment options are limited.
And then there’s the fact that annuities are expensive: all those aforementioned fees, which are rather high compared to the annual expense ratios of mutual funds or exchange traded funds (ETFs). Also, many annuity contracts allow for fee increases by the insurer, something you likely can’t avoid, except at great expense, thanks to those surrender charges.
The Bottom Line
Annuities make sense for some people. For others, they do not. For that reason, investing in an annuity—let alone doing so inside an IRA—should only be done after consulting with a qualified independent financial advisor. There may be other ways to ensure a regular income stream that don’t incur such high fees.
Divvy Investments, LLC, Cary, NC
Some people confuse IRAs for a type of investment. IRAs are vehicles that allow you to hold the investments with various tax advantages. People commonly invest in stocks, bonds, and mutual funds inside IRAs. Other options are sometimes available but can get complicated and messy. The IRS places some income limits on tax benefits as well as contribution limits.
Annuities are contracts with insurance companies. They often come with some level of guarantee, but typically at a much higher fee. A fixed annuity will pay out a predetermined amount based on the contract. A variable annuity allows you to invest money in stocks, bonds, funds, etc. Annuities don't have income or contribution limits.
Both provide potential tax advantages and deferred growth.