What’s the Difference Between an Annuity and an IRA?
Distinguish between a retirement savings account and an insurance contract designed for income to clarify their unique roles in your financial strategy.
The frequent mention of both Individual Retirement Arrangements (IRAs) and annuities can cause confusion. While both are tools designed to help secure a person’s financial future, they operate in fundamentally different ways.
Understanding the Individual Retirement Arrangement (IRA)
An Individual Retirement Arrangement (IRA) is not an investment, but a tax-advantaged savings account that holds various investments to accumulate retirement funds. The account owner directs how the funds are invested, choosing from options like stocks, bonds, and mutual funds. The main benefit of using an IRA is the tax treatment it receives.
A Traditional IRA may allow for tax-deductible contributions, which can reduce your taxable income for the year. The investments grow on a tax-deferred basis, and withdrawals in retirement are taxed as ordinary income. This structure benefits individuals who anticipate being in a lower tax bracket during their retirement years than in their peak earning years.
Contributions to a Roth IRA are made with after-tax dollars, so there is no upfront tax deduction. The benefit is that investments grow tax-free, and qualified withdrawals during retirement are also tax-free. This is beneficial for those who expect to be in a higher tax bracket in retirement or want tax-free income later in life.
The Internal Revenue Service (IRS) sets annual limits on the amount of money that can be contributed to an IRA. Withdrawals made before the account holder reaches age 59½ are subject to a 10% penalty in addition to regular income tax.
Understanding the Annuity
An annuity is a contract between an individual and an insurance company. Its function is to provide a guaranteed stream of income for a specific period or for the individual’s life. This feature creates a predictable cash flow during retirement to address the risk of outliving one’s savings.
An annuity involves two phases. The first is the accumulation phase, where the individual funds the contract with a lump sum or periodic premiums, allowing the money to grow. The second is the annuitization, or payout, phase, where the insurance company begins making regular payments back to the individual.
Annuities come in several forms, categorized by how their value increases. A fixed annuity offers a guaranteed interest rate, providing predictable growth. A variable annuity allows the owner to invest in subaccounts where returns fluctuate based on market performance. An indexed annuity links its returns to the performance of a market index, like the S&P 500.
An annuity purchased with after-tax dollars is a non-qualified annuity. The principal investment is not taxed upon withdrawal, but the earnings portion of the payments is taxed as ordinary income. This tax-deferral on growth is a primary feature of non-qualified annuities.
Comparing Core Features of IRAs and Annuities
The core difference is their nature: an IRA is a savings account for accumulating funds, while an annuity is an insurance contract for creating a reliable income stream. An IRA’s purpose is to grow savings with various investments, whereas an annuity’s purpose is to convert savings into a steady payout, like a personal pension.
IRA contributions are governed by annual limits set by the IRS. In contrast, annuity contributions are not subject to these IRS limits. Instead, they are determined by the terms of the specific insurance contract, which often allows for much larger, or even unlimited, premium payments.
The rules for accessing funds also differ. IRAs offer high liquidity, allowing the account holder to withdraw funds as needed, subject to age-based penalty rules. Annuities have low liquidity because they are designed for long-term income. Early withdrawals during the contract’s surrender period, often lasting six to eight years, can result in significant surrender charges from the insurance company.
How an IRA and an Annuity Can Work Together
An annuity is a type of investment product that can be purchased and held inside an IRA, just as one would hold a mutual fund or stock. This arrangement is known as an individual retirement annuity. When this is done, the IRA owns the annuity contract.
A person might use this strategy to access an annuity’s specific benefits, such as guaranteed lifetime income or certain death benefit provisions, while keeping assets within the IRA’s tax-advantaged structure. This allows them to use accumulated IRA funds to create a pension-like income stream, managed within the retirement account.
This approach has drawbacks, as it can create redundant tax benefits. Since a Traditional IRA already provides tax-deferred growth, placing an annuity inside it means one may be paying for a tax-deferral feature the IRA already provides. Additionally, the fees for annuities can be higher than other investment options available within an IRA.