Both individual retirement accounts (IRAs) and annuities offer tax-advantaged ways to save for retirement, but there are clear differences between them. For one thing, an IRA is not itself an asset; it is a vehicle for holding financial assets: stocks, bonds, and mutual funds. Annuities, on the other hand, are assets—specifically insurance products—designed to generate income.

 

IRAs

An IRA can be thought of as an individual investment and savings account with tax benefits. When you open an IRA, it is just for you—that is why it is called an individual retirement account. If you have a spouse, you will need separate accounts. If one partner earns little or no wages, you can use household income to open a spousal IRA to benefit your spouse and double the family's retirement savings options.

An important distinction is that an IRA is not an investment in itself. It is an account in which you hold investments such as stocks, bonds, and mutual funds. Within certain limits, you can choose the investments in the account and change them if you wish.

Your return depends on the performance of the investments held in the IRA. An IRA continues accumulating contributions and interest until you reach retirement age, which means you could have an IRA for decades before making withdrawals.

IRA Rules

The IRS regulates IRAs, establishing eligibility requirements and limits on how and when you can contribute and receive distributions. It also determines the tax treatment of the different types of IRAs.

Types of IRAs

IRAs are classified as traditional or Roth.

• All traditional IRA contributions are considered to be made with pretax dollars and are deductible in the year they are made.
• Withdrawals are taxed as income.
• Roth IRA contributions are considered to be made with after-tax dollars,
• so withdrawals are not subject to tax. (See reference 1 at the end of the article.)

 

For 2021, as for 2022, the maximum contribution to a traditional or Roth IRA is $6,000 each year ($7,000 if you are 50 or older) or your taxable income for the year, whichever is less. (See reference 2 at the end of the article.)

Under the SECURE Act, the starting date for "required minimum distributions" for most people is not until age 72. (See reference 3 at the end of the article.)

 

Traditional IRA owners must wait until age 59½ to withdraw funds, although the IRS allows early withdrawals under certain circumstances. If you have a Roth IRA, you can withdraw contributions at any time, but you will pay a penalty if you withdraw investment interest or earnings too soon. The early withdrawal penalty for both types of IRA is 10%. (See reference 1.)

 

Annuities

Annuities are insurance products that provide monthly, quarterly, annual, or lump-sum income during retirement. An annuity makes periodic payments for a certain period or until a specific event occurs—for example, the death of the person receiving payments. Money invested in an annuity grows tax-deferred until it is withdrawn.

Unlike an IRA, which generally 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. (See reference 4.)

Funding

You can "fund" an annuity all at once, which is known as a single premium, or pay into it over time. (Reference 4.)

Income Flow

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 specified period until you begin making withdrawals, generally during retirement.5 As with IRAs, you will be penalized if you try to withdraw funds from the deferred annuity before the payout period begins. (Reference 6.)

Annuity Payments: Fixed or Variable

Both immediate and deferred annuities can make payments at a fixed or variable rate.

With a fixed annuity, the financial institution manages the funds. You have no say in how that money is invested. Once annuitization occurs, you are paid a fixed amount, either as a lump sum or in payments over several years or for life.

 

Variable annuities allow you to choose among different investment options (reference 7 below), including mutual funds, bond funds, and money market accounts. The equity-indexed version follows a specific stock market index, such as the S&P 500.

Obviously, choosing a variable rate offers the possibility of higher returns, but it also carries greater risk.

A variable annuity is the most comparable to an IRA. Both are essentially tax-sheltered wrappers that hold investment funds. However, variable annuities have higher annual expenses than IRAs.

 

Annuity Fees

Because an annuity is essentially an investment instrument inside an insurance policy, fees can be high. You pay insurance fees, investment management fees, fees if you try to exit the contract—also known as surrender charges—and fees for riders, which are optional additions to the basic contract, such as one guaranteeing a minimum increase in annuity payments each year.

Expense Ratios in IRAs

An IRA, on the other hand, carries, at best, a small custodial fee charged by the financial institution holding your account. Of course, mutual funds within the IRA charge their own annual management fees, called expense ratios.

 

Taxes on Annuity Payments

Essentially, taxes are paid on annuity distributions and apply to the portion of the distribution that was not initially taxed. (Reference 6.)

• If you buy the annuity with pretax 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. (Reference 6.)

 

Calculating which portion is which can be somewhat complicated because it involves something called the exclusion ratio, which divides your withdrawals across your life expectancy.
Your accountant can perform the calculations, or the annuity issuer can send you a year-end statement showing the principal and earnings portions of the payment.

 

Buying with Tax-Free Funds (IRA/Roth)

If you use funds from your Roth IRA or Roth 401(k) to buy a fixed immediate annuity when you retire, all payments will be tax-free because the source of those funds, your Roth IRA, is tax-free. However, keep in mind that when you purchase with these funds, regular Roth distribution rules apply: you must be older than 59½ and have held the account for at least five years. (References 8 and 9.) The same applies to holding a deferred annuity within your Roth IRA.

 

Should I Hold My Annuity in an IRA?

If you place an annuity inside an IRA, the IRS rules for the IRA override the rules for the annuity. This means any unfavorable tax treatment of payments is irrelevant if the annuity is held within the IRA. However, the advantage of a steady, guaranteed, tax-free income stream in retirement could well justify placing part of your assets in such an annuity. That is the perspective from the payout side.

 

From the investment growth perspective, there are some drawbacks if you are relatively young—or at least a few decades from retirement—when purchasing a deferred annuity.

• You would be placing a tax-advantaged instrument, the annuity, inside a tax-sheltered account, the IRA. This seems unnecessarily redundant.
• There is the issue of illiquidity. Most annuities carry high surrender charges if you decide to withdraw money and invest it elsewhere. (See reference 10.)
• With a fixed annuity, you have no say in how those funds are invested.
• If your annuity is variable, your investment options are limited.

 

 

Investing in an annuity, especially within an IRA, should be done only after consulting a qualified, independent financial advisor.

 

Some people mistake IRAs for a type of investment. IRAs are vehicles that let you hold investments with various tax advantages. People commonly invest in stocks, bonds, and mutual funds within IRAs. Other options are sometimes available, but they can become complicated and difficult to manage. The IRS sets certain 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 generally at a much higher cost. A fixed annuity pays a predetermined amount based on the contract. A variable annuity lets you invest money in stocks, bonds, funds, and so on. Annuities have no income or contribution limits. Both offer potential tax advantages and tax-deferred growth.

 

 

 

 

References and Information Sources

1. Internal Revenue Service. "Traditional and Roth IRAs."
2. Internal Revenue Service. "IRS Announces 401(k) Limit Increases to $20,500."
3. Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs."
4. Internal Revenue Service. "Publication 939 (12/2018), General Rule for Pensions and Annuities."
5. Insurance Information Institute. "What Are the Different Types of Annuities?"
6. Internal Revenue Service. “Topic No. 410, Pensions and Annuities.”
7. U.S. Securities and Exchange Commission. "Variable Annuities: What You Should Know," pages 5–6.
8. Internal Revenue Service. "Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)," pages 30–31.
9. Internal Revenue Service (IRS). "Designated Roth Accounts—Distributions."
10. U.S. Securities and Exchange Commission. "Variable Annuity Fees and Expenses."