What Is an Individual Retirement Annuity?

An individual retirement annuity is an investment vehicle similar to an individual retirement account (IRA) that is sold by insurance companies.

Key Takeaways

  • An individual retirement annuity is an insurance contract that works much like an individual retirement account, or IRA.
  • Individual retirement annuities invest only in fixed or variable annuities, while IRAs offer a wide range of investments.
  • Like IRAs, individual retirement annuities come in both traditional and Roth versions. Depending on the type, the owner can either take an upfront tax deduction or receive tax-free income later.

How an Individual Retirement Annuity Works

Like other types of annuities, an individual retirement annuity is a contract between an individual and an insurance company. The individual contributes an agreed-upon amount, and the insurer promises to pay money back, with interest, at some future date, either in the form of a lump sum or as a series of regular payments. Individuals often buy annuities to supplement their other retirement income, such as Social Security.

Individual retirement annuities can take the form of a fixed annuity or a variable annuity. Fixed annuities pay a set rate of interest, while variable annuities base their return on a portfolio of mutual funds chosen by the annuity owner. During what's known as the accumulation phase, the money in the annuity account grows tax-deferred.

Individual retirement annuities bought within an IRA have the same contribution limits, catch-up provisions, and basic tax advantages as IRAs. For 2020 (as it was for 2019), the annual contribution limit is $6,000 for people under age 50. Those 50 and over are eligible to make an additional $1,000 catch-up contribution, for a total of $7,000.

Also like IRAs, individual retirement annuities are available in both traditional and Roth versions. With the traditional version, the owner's contributions are generally tax-deductible for the year they are made, but withdrawals are taxed later on. The Roth version provides no upfront tax deduction but later withdrawals can be tax-free.

When the annuity owner begins receiving regular income from the account—known as the payout phase—that money will be taxed as ordinary income, in the case of a traditional individual retirement annuity, or not taxed, in the case of a Roth. This is also how traditional and Roth IRAs work.

A number of specific rules apply to individual retirement annuities. The annuity must be issued in the owner's name, and only the annuity owner or their surviving beneficiaries are eligible to receive benefits from the contract. The owner's entire interest in the annuity must be fully vested, and the owner is not allowed to transfer any of the balance to another person (though they may name a beneficiary to receive the money after their death). The annuity's premiums must be flexible, so the owner can change the amount of their payments if their income changes.

Individual retirement annuities are more limited in their investment choices than IRAs, which can invest in many different types of securities.

Individual Retirement Annuity vs. Individual Retirement Account

The biggest difference between individual retirement annuities and IRAs is the types of investments they hold. Individual retirement annuities are limited to fixed and variable annuities only. IRAs can hold a wide range of investments, including stocks, bonds, mutual funds, and real estate.

Annuities are also known for their often-high fees, so IRAs are likely to be a more economical way to invest for retirement.