First, it’s important to establish that annuities and IRAs are two separate categories, but they can be used together as well. (You can own an annuity separate from an IRA OR you can own an annuity WITHIN an IRA.)
We’ll explain what distinguishes the two, how to think about each, and how it may make sense to utilize both. Our goal is to help you to make an informed decision based on your unique circumstances.
Whether you’re a retirement planning novice or a seasoned investor, understanding the intricacies of annuities and IRAs can be a foundational aspect of retirement planning. Join us as we explore how these savings tools may play a role in your golden years.
What Are Annuities and IRAs?
When it comes to saving for retirement, you’ve got options. Two popular choices are annuities and IRAs. But what exactly are they? Put simply:
An annuity is a contract between you and an annuity company.
An IRA is an individual retirement account in your name.
Definition of Annuities
Annuities are contracts that are generally designed to provide a consistent stream of payments over time, typically during retirement. You make an initial deposit, either in a lump sum or periodic contributions, and the annuity has the potential to grow.
Annuities can be pre or post-tax. The earnings are tax-deferred. Post-tax annuities (or Nonqualified) get taxed on just the gains, while pre-tax annuities (or Qualified) get taxed on every dollar as income. When you’re ready to start receiving payments, the annuity can provide a guaranteed income for a set period or even for life.
Definition of IRAs
IRAs, or Individual Retirement Accounts, are tax-advantaged investment accounts designed to help you save for retirement. There are several types of IRAs, including traditional IRAs and Roth IRAs, each with its own tax benefits and rules. With an IRA, you can invest in a variety of assets such as money market funds, stocks, bonds, REITs, ETFs, Mutual Funds, or even … annuities!
How Annuities and IRAs Work
Both annuities and IRAs can play a role in your retirement savings strategy, but they work differently.
Annuities are insurance contracts that come in different shapes and sizes. The general idea is that you reach an agreement with an annuity company on the specific terms of your contract, you pay them a lump sum or a series of payments, and then at some point, you turn on an income stream from that contract.
IRAs are investment accounts that are designed for retirement. IRAs give you more control and liquidity of your funds. You decide how to invest the money based on your goals and risk tolerance. You can choose from a range of investment options and your account balance will fluctuate depending on the investments you select.
Types of Annuities
Not all annuities are created equal. There are several different types, each with its own features and benefits. Rather than overwhelming you with all the potential features of each, here are some of the most common features with a brief description of what differentiates them:
- Fixed Annuities – An annuity that provides regular, guaranteed interest rate over a specified period.
- Variable Annuities – An annuity where account value can vary based on the performance of investments chosen by the annuitant.
- Indexed Annuities – An annuity with returns tied to a specific market index, offering the potential for higher gains while often limiting downside. (Although the upside in the index is usually capped)
- Immediate Annuities – An annuity that begins making payments to the annuitant immediately after a lump sum investment.
- Deferred Annuities – An annuity that delays payments to the annuitant until a future date, allowing the investment to grow tax-deferred.
Types of IRAs
Just like there are different types of annuities, there are also different types of IRAs. The two main types are traditional and Roth IRAs.
- Traditional IRAs – Traditional IRA contributions are generally tax deductible in the year of the contribution. The funds invested have the potential to grow tax-deferred, meaning you won’t pay taxes on your investment earnings until you withdraw the money in retirement.
- Roth IRAs – Roth IRA contributions are made with after-tax dollars, so there’s no upfront tax deduction in the year of the contribution. However, the funds have the potential to grow tax-free, and you can withdraw your contributions and earnings tax-free in retirement.
- Other – There are IRAs that can be provided through work or for self-employed individuals as well called SEP and SIMPLE IRAs. They function in a similar fashion to traditional IRAs but a notable difference is their larger contribution limits.
Annuities or IRA: Key Differences Between Them
While both annuities and IRAs can help you save for retirement, there are some key differences to consider.
Contribution Limits
IRAs have annual contribution limits set by the IRS. For 2024, people under age 50 can contribute up to $7,000 per year. For those 50 and older, there is an additional $1,000 catch-up contribution bringing the total limit to $8,000. Nonqualified annuities don’t have annual contribution limits, but qualified annuities are limited to the same limits as IRAs.
If you already have funds in an IRA that you want to move into an annuity, then the yearly contribution limits would not apply because those funds are already in an IRA. (Not the same as making a contribution)
Investment Options
With an IRA, you have a wide range of investment options, including stocks, bonds, mutual funds, and ETFs. You can choose investments that align with your goals and risk tolerance.
Annuities typically offer fewer investment options, but some have more selection options than others. Annuities also do not always have the same level of flexibility of moving from one investment option to another once your selection has been made.
Withdrawal Rules
Both annuities and IRAs have rules around when you can withdraw your money without penalty. For both Annuities and IRAs you generally must be age 59½ or older to avoid a 10% early withdrawal penalty, although there are some exceptions.
Annuities may have surrender charges if you withdraw your money within the first few years of the contract. The surrender charge is a very large reason why you want to consider your options carefully before committing yourself to an annuity.
Fees and Expenses
Annuities can come with fees that include mortality and expense charges, administrative fees, and investment management fees. IRAs may have annual account fees, transaction fees, and fees associated with the underlying investments such as mutual fund expenses.
Advantages and Disadvantages of Annuities
Steady Income – One of the main benefits of annuities is the potential for steady income in retirement.
Tax-Deferred Growth – Annuities offer tax-deferred growth, meaning you won’t pay taxes on your investment earnings until you start receiving payments.
Death Benefits – Annuities MAY pass on and MAY NOT pass on to beneficiaries. This depends on annuitization status as well as any death benefit ‘Rider’ that was added to the agreement. Including a death benefit on an annuity can result in a lower overall cash benefit for the original owner in order to leave funds to compensate the beneficiary.
Lack of Liquidity – The funds invested in an annuity are no longer as easily accessible as they were prior to the contract because those funds have been designated for future income payments. This lack of liquidity is a key characteristic of annuities and should be considered carefully before investing. Annuities often have surrender charges if you withdraw money within the first few years of the contract.
Fees – Annuities can come with fees, which can affect returns. It’s important to understand all the costs associated with an annuity before investing.
Complexity – Annuities can be complex products, with various types, features, and riders available. This complexity can make it difficult for investors to fully understand what they’re buying and how it will impact their retirement savings.
Inflation – Annuities can be linked to a fixed rate, and during times that inflation is higher than usual, the steady nominal income stream may not be sufficient to keep up with the increased cost of living.
Advantages and Disadvantages of IRAs
Tax Benefits – Traditional IRAs can offer tax benefits in the year of contribution, while Roth IRAs can offer tax free withdrawals later in life. Traditional IRAs also have tax-deferred status similar to annuities.
Investment Flexibility – IRAs offer a wide range of investment options, giving you the flexibility to choose investments that align with your goals and risk tolerance.
Estate Planning – Roth IRAs get inherited still tax-free for the recipient. Traditional IRAs get inherited with withdrawals still being subject to taxable income rates.
Income Limits – The income limits for both Roth and traditional IRAs may limit some investors from taking full advantage of these accounts throughout their lives.
Required Minimum Distributions – With a traditional IRA, you must start taking required minimum distributions (RMDs) once reaching age 73 (Under current rules). This can be a disadvantage, as you’ll have to pay taxes on the withdrawals. (This also applies to Qualified Annuities)
Choosing Between an Annuity and an IRA
So, how do you decide between an annuity and an IRA? It ultimately depends on your financial situation, preference, and retirement goals. Some people decide to go with both options!
Assess Your Financial Goals
Start by assessing your financial goals. If steady income with limited downside is a top priority, an annuity may be a good choice. If you want more control over your investments and the potential for higher returns, an IRA may be a better fit.
Consider Your Age and Retirement Timeline
Your age and retirement timeline can also impact your decision. If you’re closer to retirement and want a steady income stream, an annuity may make sense. If you have a longer time horizon and want to take advantage of the power of compounding, an IRA may suit you better.
Evaluate Your Risk Tolerance
Consider your risk tolerance when choosing between an annuity and an IRA. Annuities generally offer more predictable returns and less risk, while IRAs allow you to invest in a wider range of assets with varying levels of risk.
Compare Fees and Expenses
Don’t forget to compare the fees and expenses associated with annuities and IRAs. The details of all the fees can be a little complex to dissect, so make sure that you’re very clear on the potential fees for each route.
Consult with a Financial Advisor
Given the complexity of annuities and the various factors to consider when choosing a retirement investment vehicle, it’s wise to consult with a financial advisor. They can help you evaluate your options and make a decision based on your unique financial situation and goals.
Annuities and IRAs: Final Thoughts
Annuities and IRAs: each have their own unique benefits and drawbacks when it comes to planning for retirement. Often, it is not an ‘either this or that’ decision. Many people opt to utilize both in some form or another.
In general, it comes down to preference, financial situation, and retirement goals with a few major variables at play:
- Age
- Risk Tolerance / Comfort Level with Volatility
- Value of Total Assets
- Individual Philosophy on Investing
- Desire for Liquidity / Optionality
If you’re uncomfortable navigating all the variables and options to consider, we don’t recommend that you come to this decision on your own. And we also don’t recommend that you speak to someone that only sells annuities to help you reach this decision either.
A holistic fiduciary financial advisor can guide you through the decision-making process and help get you on track to achieve your financial goals. For more information, schedule a no-obligation financial assessment with our team today.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
