Can an IRA Be an Annuity? Key Things You Need to Know

An Individual Retirement Arrangement (IRA) is a retirement savings account offering tax advantages to individuals with earned income. These accounts are designed to help people save for their future, often complementing employer-sponsored plans. An annuity, on the other hand, is a contract with an insurance company that provides a stream of payments, typically for retirement. An annuity can be purchased and held inside an IRA. This article will explain the nature of annuities, how they are integrated into IRAs, the different types of annuities suitable for IRAs, and the tax rules that apply to such arrangements.

What an Annuity Is

An annuity is a financial contract purchased from an insurance company. In exchange for a lump sum or a series of payments, the insurance company promises to provide regular disbursements, either immediately or at a future date. Annuities are primarily designed to offer a steady stream of income, often for retirement, and can help address concerns about outliving savings.

Annuities typically involve two main phases. The first is the accumulation phase, during which the money paid into the contract grows on a tax-deferred basis. The second is the payout, or annuitization, phase, when the contract owner begins receiving regular payments. These payments can last for a specified period or for the rest of the annuitant’s life.

Integrating Annuities into an IRA

An annuity held within an IRA functions as an investment option, similar to how stocks or mutual funds might be held in the account. An annuity is not a separate type of IRA itself. Instead, the IRA serves as the “wrapper” or container for the annuity contract.

To integrate an annuity, funds are first contributed to the IRA, which can be a Traditional or Roth IRA. The IRA custodian or trustee then uses these funds to purchase the annuity contract. The tax-deferred growth characteristic of the annuity within this arrangement is primarily due to the IRA wrapper, not an additional tax deferral from the annuity itself.

Types of Annuities Held in IRAs

Several types of annuities can be held within an IRA, each offering different features and risk profiles. Fixed annuities provide a guaranteed interest rate, ensuring predictable growth and payments. A common type of fixed annuity is a Multi-Year Guaranteed Annuity (MYGA), which offers a fixed rate for a specific term, typically three to ten years. Fixed annuities are often chosen for their principal protection and reliable income generation.

Variable annuities, conversely, allow investment in underlying sub-accounts that are similar to mutual funds. Their value and payout potential fluctuate based on the performance of these investments, offering the possibility of higher returns but also carrying market risk. These annuities typically come with various fees, including those for investment management and insurance features.

Indexed annuities link their growth to a market index, such as the S&P 500. They generally offer a balance between growth potential and protection, often including caps on gains and floors on losses. This structure aims to provide some participation in market upside while shielding against significant downturns.

Tax Rules for IRA Annuities

The tax treatment of annuities held within an IRA is primarily governed by the IRA’s tax-deferred status. All earnings and growth within the annuity, and the IRA itself, accumulate tax-deferred. This means taxes are not paid on the investment gains until funds are withdrawn from the IRA.

When distributions are eventually taken from a Traditional IRA that holds an annuity, all amounts withdrawn, including both contributions and earnings, are generally taxed as ordinary income. This applies regardless of whether the distribution represents annuity interest, investment gains, or original principal that was tax-deductible when contributed. For Roth IRAs, qualified distributions of both contributions and earnings are tax-free because contributions are made with after-tax dollars.

Annuities held within IRAs are also subject to Required Minimum Distribution (RMD) rules. For individuals who turned 73 in 2023 or later, RMDs generally must begin by April 1 of the year following the year they reach age 73. Subsequent RMDs must be taken by December 31 of each year. The amount of the RMD is calculated based on the IRA balance and the account owner’s life expectancy, as determined by IRS tables. Failure to take RMDs can result in a penalty of 25% of the amount not withdrawn, which may be reduced to 10% if corrected within two years.

Holding an annuity inside an IRA does not provide an additional layer of tax deferral beyond what the IRA already offers. Therefore, the primary reasons for combining them often relate to the annuity’s specific contractual guarantees, such as guaranteed lifetime income or principal protection, rather than further tax advantages.