Can an IRA Be an Annuity? How They Work Together

The relationship between an Individual Retirement Arrangement (IRA) and an annuity can be confusing. While both are tools for retirement savings, they serve different purposes. An IRA is a tax-advantaged account structure, not an investment itself, while an annuity is a specific financial product. They can be combined by holding an annuity inside an IRA, but this approach has specific costs and complexities to consider.

The IRA as a Container and the Annuity as an Investment

An Individual Retirement Arrangement, or IRA, is best understood as a tax-advantaged savings account structure. It is not an investment itself, but rather a “container” that holds various investments and protects them from certain taxes. The two most common types are the Traditional IRA, where contributions may be tax-deductible and withdrawals are taxed in retirement, and the Roth IRA, where contributions are made with after-tax dollars but qualified withdrawals are tax-free. Within this IRA container, an individual can hold a wide array of financial products, such as stocks, bonds, and mutual funds.

An annuity, by contrast, is a contract with an insurance company. The purpose of an annuity is to provide a stream of income, which can begin immediately or at a future date, and can be guaranteed for life. It is one of the many investment options that can be purchased and held inside an IRA. When an annuity is held within an IRA, it is often called an “IRA annuity,” which is different from a “non-qualified” annuity purchased with after-tax money outside of a retirement account.

How Annuities Function Within an IRA

When an individual decides to place an annuity within their IRA, they use the cash held in the retirement account to purchase the contract from an insurance company. The annuity then becomes an asset owned by the IRA. The value of the annuity grows according to its specific terms, all while remaining sheltered within the tax-advantaged IRA container. The process is facilitated by the IRA custodian, who handles the transfer of funds to the insurance company.

There are several types of annuities that can be held within an IRA, each with different methods for generating returns. A fixed annuity is the most straightforward, offering a guaranteed interest rate for a specified period. This provides a predictable return on the principal investment and appeals to those seeking to protect their principal from market fluctuations.

A variable annuity’s value is tied to the performance of underlying investment options, similar to mutual funds, called subaccounts. The owner can allocate their premium among various stock, bond, and money market funds. This means the annuity’s value can rise or fall with the markets, offering greater potential for growth but also exposing the principal to investment risk.

An indexed annuity’s return is linked to the performance of a specific market index, such as the S&P 500. The contract includes features like a cap, which limits the maximum potential gain, and a floor, which often guarantees that the principal will not lose value from market downturns. This structure allows for some participation in market gains while offering a degree of protection against losses.

Key Tax and Withdrawal Considerations

Placing an annuity inside an IRA creates tax-deferral redundancy. Both IRAs and annuities have tax-deferral as a core feature. When an annuity is held within a Traditional IRA, you are not gaining an additional tax advantage, but you are taking on the annuity’s fee structure.

An annuity also affects Required Minimum Distributions (RMDs). Under IRS rules, owners of Traditional IRAs must begin taking withdrawals starting at age 73. The RMD amount is calculated annually by dividing the account’s fair market value by a life expectancy factor from the IRS’s Uniform Lifetime Table. The value of a deferred annuity held in the IRA must be included in this total account balance calculation.

Failure to take the full RMD results in a 25% penalty on the amount that should have been withdrawn, which can be reduced to 10% if the shortfall is corrected in a timely manner. If the annuity has been “annuitized” into a stream of regular payments, those payments can satisfy the RMD for that portion of IRA assets. However, those payments cannot be used to satisfy the RMD for other IRA assets held outside the annuity.

Roth IRAs are not subject to RMDs during the original owner’s lifetime, so these specific withdrawal rules do not apply.

Evaluating Fees and Contractual Terms

Annuities have their own fees that are separate from any administrative or custodial fees charged for the IRA itself. These costs are detailed in the annuity contract and can impact the net return of the investment. Common charges include:

• Mortality and expense (M&E) risk charge, which compensates the insurance company for the risks it assumes and ranges from 0.50% to 1.50% annually.
• Administrative fees, which can be a flat annual charge of around $30 to $50 or an asset-based fee between 0.10% and 0.30%.
• Management fees for the underlying investment subaccounts in a variable annuity, which are similar to those in mutual funds and can range from 0.25% to over 2.00%.
• Optional features, known as riders, for benefits like guaranteed lifetime income or enhanced death benefits, which carry their own separate annual fees.

Another term to understand is the surrender charge. This penalty is assessed for withdrawing more than a specified amount from the annuity before a certain period has passed, often lasting six to eight years. The charge is a percentage of the amount withdrawn and declines over time; for example, it might start at 7% in the first year and decrease by one percentage point each subsequent year.

Because these costs reduce investment growth, you should review the annuity prospectus and contract to understand the full fee structure and surrender charge schedule before making a purchase.