Individual retirement accounts (IRAs) and annuities both provide tax-advantaged ways to save for retirement, but there are distinct differences between the two. An IRA is a type of investment account, while annuities are income-producing insurance products commonly used by retirees.

Let's take a look at how each work.

Understanding IRAs

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).

Key Takeaways

  • 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.

An important distinction to make 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.

IRA Rules

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 the various types of IRAs.

There are two main types or 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.

In 2019, the maximum you can contribute to your traditional or Roth IRA is the lesser of $6,000 ($7,000 if you're age 50 or older) or your taxable income for the year.

Traditional IRA account holders must take required minimum distributions annually starting at age 70½ , but Roth IRAs don't have this requirement.

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. The early withdrawal penalty for both types of IRAs is 10%.

Understanding Annuities

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 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.

Annuities typically have higher expenses than IRAs. Also, like IRAs, if you take early withdrawals you'll owe a penalty.

Advisor Insight

Nick Bradfield
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.