Saving for retirement can be an incredibly daunting process — especially if you do not know where to begin. You may have heard of individual retirement accounts (IRAs) and annuities, but if you haven’t taken the time to truly understand and compare these two tax-advantaged retirement savings plans, figuring out which to use can be impossible.
Here, we will explore both annuities and IRAs and help you understand the differences between them as well as why you may prefer one to the other.
| Features | Annuities | Individual Retirement Accounts (IRAs) |
|---|---|---|
| Type of Account | Insurance-based investment product | Personal retirement savings account |
| Contribution Limits | No IRS-imposed contribution limits | Contribution limits set by IRS |
| Tax Treatment | Contributions are made with after-tax dollars | Contributions may be tax-deductible (Traditional) |
| Tax-Deferred Growth | Earnings grow tax-deferred | Earnings grow tax-deferred |
| Withdrawal Rules | Generally subject to surrender charges and penalties | Subject to early withdrawal penalties and tax consequences |
| Annuity Payouts | Can provide regular income for life | Withdrawals and various payout options |
| Investment Options | Variety of options, including fixed and variable annuities | Wide range of investment options |
| Required Minimum Distributions (RMDs) | Required starting at age 72 | Required starting at age 72 |
| Portability | Generally less portable than IRAs | Portable and can be transferred or rolled over |
| Contribution Limitations | No contribution limitations | Contribution limits set by IRS |
| Investment Control | Limited control over investment decisions | More control over investment decisions |
| Creditor Protection | May offer some creditor protection | May offer some creditor protection |
| Professional Management | Often includes management by insurance company | Self-directed or managed by professional advisors |
| Estate Planning Considerations | Can include certain estate planning benefits | May provide for designated beneficiaries and estate planning |
| Accessibility | May have limitations on accessing funds | Generally accessible after age 59½ |
| Risk Tolerance | Generally lower risk, but lower potential returns | Risk depends on the investment choices made |
| Contribution Flexibility | Generally no contribution flexibility | Contribution amount can be adjusted annually |
| Investment Education and Resources | May provide limited educational resources | No specific educational resources provided |
| Tax Implications at Withdrawal | Taxed as ordinary income | Taxed as ordinary income (Traditional) or tax-free (Roth) |
| Self-Employed Individuals | Annuities can be purchased individually | Self-employed individuals can establish a SEP-IRA or Solo 401(k) |
| Early Withdrawal Penalties | May have surrender charges and penalties | Subject to early withdrawal penalties |
| Employer Involvement | Not employer-sponsored | Employer-sponsored plans may be available (e.g., SEP-IRA, SIMPLE IRA) |
| Rollover Options | Can be rolled over to another annuity or IRA | Can be rolled over to another IRA or employer-sponsored plan |
What Is an Annuity?
Put simply, an annuity is an insurance contract that is designed to provide its investors with a steady and reliable stream of income during their retirement. These plans offer their investors certain tax benefits, and the money that is invested in an annuity grows tax-free until you begin receiving payments. The money in your annuity is referred to as “tax-deferred” because you will be required to pay taxes on it when you receive payments during your retirement.
Just like any type of insurance plan or product, you pay premiums to insurance companies in return for the protection that your insurer offers to your retirement money. These premiums function as the income stream that your annuity will pay you once you begin getting payments in your retirement.
Some annuity plans allow you to pay the entire premium at once while others require you to pay it gradually over time — and some give you a choice. You can also choose when your annuity payments begin, how long they will last, and whether or not you would like them to be made to your spouse after your death.
Types of Annuities
There are three basic types of annuities. These are fixed, equity-index, and variable. Here we will explore each of these types but note that they can be adapted to fit particular circumstances and needs. These are simply the basic variety of annuities that are available.
Fixed Annuity
The first type of annuity is a fixed annuity. With this type of annuity, you receive a fixed payment from the insurance company for the duration of your retirement. This offers a reliable and predictable rate of return for your premium.
At first, this may seem like the best option because it offers a reliable amount of income for you to live on during your retirement. But, it is important to keep in mind that inflation can cause this fixed amount to be worth less than it was when you were paying your premiums to the insurance company.
In summary, with a fixed annuity, you pay a premium to the insurance company over a period of time. After an agreed-upon period of time, the insurance company will pay you a fixed amount on the schedule that you set.
Variable Annuity
The second type of annuity is called a variable annuity. Unlike fixed annuities, variable annuities offer payments based on the performance of your premium investments. When you select a variable annuity plan, you can choose from a list of investment options — such as mutual funds and money-market accounts. Your payments will be based on your choices and the performance of your investments.
Because of this, variable annuities are typically considered to be the most likely to offer greater returns during retirement, but they are also the riskiest type of annuity. Since this type of annuity is essentially an account that houses your investment funds, it is the closest type of annuity to an IRA — but we will get into what an IRA is later on. It is important to note, however, that while variable annuities are the closest in practice to an IRA, they typically have higher annual expenses than IRAs do.
In summary, in a variable annuity, the payments you receive from your insurance company will depend on the investment performance of your premium. This makes it a good option for individuals who do not mind the possibility of fluctuations in their retirement income.
Equity-Index Annuity
The last type of annuity is called an equity-indexed annuity. Sometimes it is referred to as a fixed-index annuity as well. This type of annuity offers features of both fixed and variable annuities. This means that part of your annuity will be tied to how well or poorly the investment performance of your premium does, while the other part of your annuity will come to you in a fixed payment.
Typically, this type of annuity is regarded as the most beneficial because you have the ability to receive additional money if your premium investments perform well, but you do not have to worry about not getting anything if they do poorly.
In summary, an equity-index annuity combines the features of fixed and variable annuities so that you end up receiving a smaller reliable payment in addition to a portion that is tied to the performance of your investments.
Annuity Fees
Annuities tend to be quite complex due to the fact that they are very customizable. However, in addition to being complicated, the more you customize your annuity plan, the more expensive it will end up being.
Like other insurance plans, there are a number of fees that come with an annuity plan. Some of these include the insurance itself, investment management, and surrender charges (a fee that is taken if you try to get out of the contract at any time).
Pros of Annuities
There are a number of benefits to selecting an annuity plan for your retirement. Typically, annuity plans are more reliable than relying solely on investments (unless, of course, you are opting for a variable annuity plan). This makes them a good option for individuals who have fixed expenses that they will need to pay in their retirement or individuals who may worry about running out of money during retirement.
- The money you have in your annuity is not taxed until you withdraw it. Since many people end up in a lower tax bracket in their retirement, this may mean that you end up paying fewer taxes on your retirement money overall.
- There are no set contribution limits on how much you can add to your annuity fund. However, your insurer can set their own limits on what they will accept for the annuity.
- You receive guaranteed income during retirement.
- You can select what type of annuity you get and whether or not you would like to include a death benefit in your plan.
- Annuity plans are very customizable.
Cons of Annuities
Just like any other type of insurance or retirement plan, there are disadvantages to selecting an annuity plan. Some of these include:
- If you are relying on a fixed annuity plan or otherwise rely on a fixed payment amount, it may end up being worth less in your retirement due to inflation.
- Annuity plans can be complicated and hard to understand, so it may take longer for you to get one set up.
- Annuity plans typically have more and higher charges than IRAs do.
- They may also have “surrender charges” if you decide to change or cancel your plan.
- You will typically have limited or no say in the type of investments that your annuity plan makes.
What Is an IRA?
IRAs, or individual retirement accounts, are essentially savings and investment account that offer tax benefits. To get an IRA, you have to open the account yourself (with the help of a financial advisor or bank). As an IRA is an individual account, it can only be made in one person’s name. Therefore, if you have a spouse, you must each make separate IRA accounts.
One important note about IRAs is that they are not an investment but rather an account that holds the various investments you are making. These can include investments like stocks and bonds. While you typically do not have complete control over your IRA investments, as this is usually the job of the financial advisor monitoring your account, you can choose where you would like to invest and change investments if you would like.
The amount of money that you get from your IRA will depend on how your investments perform.
Types of IRAs
Like annuities, there is more than one type of IRA. IRAs have two primary types: traditional and Roth. In addition to these two types is one more type of IRA account, but we will touch on this third type last as it is technically an exception to one of the rules for creating an IRA.
So, without further ado, here are the types of IRAs.
Traditional IRA
The first type of IRA account is a traditional IRA. These accounts use pre-tax dollars. A traditional IRA allows you to get a tax break on any contributions you make to the account over the year. However, since traditional IRAs use pre-tax dollars, you will have to pay taxes when you make withdrawals from this account.
In other words, with a traditional IRA, you contribute pre-tax dollars that grow tax-free in the account, and you then pay taxes on that money when you withdraw it.
In order to make withdrawals from your traditional IRA without penalties, you must wait until you are age 59.5 years old. You are not required to make withdrawals before the age of 73. After you turn 73, however, you must start making withdrawals from this account. At this age, you must begin withdrawing at least the required minimum distribution (RMD) each year. This amount can be calculated using the worksheets on the IRS’s website. You can make early withdrawals, but the money you withdraw will be penalized (typically a 10% reduction).
In summary, traditional IRAs allow you to receive tax breaks on your contributions, but any money you withdraw from the account will be taxed upon withdrawal.
Roth IRA
Roth IRAs are quite similar to traditional IRAs, but they have one major difference. Rather than making your contributions with pre-tax dollars, in a Roth IRA, you make your contributions after paying taxes on your income. This means that your contributions do not offer you a tax break when you put them into the account. This means that any money you withdraw from this account will not be subject to taxes when you withdraw it.
Basically, like a traditional IRA, your money grows tax-free in your account, but unlike a traditional IRA, you are required to pay taxes on your contributions before adding them to the account.
Roth IRAs have the same minimum age requirement for making penalty-free withdrawals as traditional IRAs, but unlike traditional IRAs, there is no age at which you must begin withdrawing money from your account. Early withdrawals will typically face a penalty of 10%, and you may be required to pay taxes on any gains.
In summary, a Roth IRA allows you to make tax-free withdrawals from your account, but it does not offer tax breaks on contributions.
Spousal IRA
The final type of IRA is a spousal IRA. It is important to note that a spousal IRA can be made as either a traditional or Roth IRA. These IRAs are not joint accounts but rather a way for a working spouse to contribute to an IRA for their spouse who makes no or very little income. This allows married couples with only one stream of income to contribute double the amount as having only one IRA account would allow them.
The purpose of this type of IRA is to act as an exception to the rule that a person must have an income in order to create an IRA. This is essential for married couples with only one working spouse who wishes to contribute more to their retirement than they would be allowed in a single IRA account. It is important to note, however, that all contributions made to both spouses’ IRAs must not exceed the working spouse’s income.
In summary, a spousal IRA allows you to essentially treat the income that the working spouse earns as mutual funds in the sense that they can be used to contribute to an IRA for the spouse who does not work.
IRA Rules
Both traditional and Roth IRAs have contribution limits imposed by the IRS. For example, the tax-free annual contribution limits in 2022 for a traditional IRA were up to $6,000 a year for someone under 50 and $7,000 for someone 50 or older. For 2023, these numbers will rise to $6,500 for individuals under 50 and $7,500 for individuals aged 50 or over. These same numbers apply for Roth IRAs, but the contributions are taxed before they go into the account, as mentioned above.
Pros of IRAs
Individual retirement accounts are one of the most popular types of retirement savings plans today, and for a good reason. IRAs offer a number of benefits to their account holders. Some of these include:
- Control of investment decisions, and you keep all of the gains when your investments do well.
- Lower and more straightforward fees than annuity fees.
- Beneficiary options for passing your IRA on to a spouse or child.
- Contributions to traditional IRAs are tax-deductible.
- Withdrawals from Roth IRAs are tax-free.
- Earnings grow tax-free in your account.
Cons of IRAs
Just like any other type of retirement plan, individual retirement accounts have disadvantages as well. Some of these include:
Limits on how much you can contribute to your account each year.
- There are limits on income when creating and contributing to an IRA.
- You cannot contribute to a Roth IRA if you earn over a certain amount.
- You have to pay attention to the tax rules regarding your type of IRA account.
- If you have a traditional IRA, you must ensure that you pay taxes on your money when you withdraw it.
- If you have a Roth IRA, you must pay taxes on your money before you contribute it to the account.
- Penalties for early withdrawal of funds.
- If your investments do not do well, you could lose money.
- The possibility of running out of money in retirement if you did not save enough in your account.
So, What’s the Difference?
Both annuities and IRAs offer significant tax advantages and ways to grow your retirement savings. But, these plans use different structures and strategies to help you grow these savings. The primary differences between these two retirement savings plans are as follows.
Tax Benefits
While both IRAs and annuities offer tax benefits, the particular plan you select will determine what those tax benefits are.
Annuity plans offer tax-deferred growth until you begin withdrawing payments. This means that once you begin receiving your payments, you will have to pay taxes on the annuity account’s earnings.
A traditional IRA works in a similar fashion as you must make your contributions with pre-tax dollars and must pay tax when you withdraw funds from the account. A Roth IRA, on the other hand, gives owners the benefit of tax-free growth and tax-free withdrawals because the contributions are made with after-tax dollars.
Purpose
One of the largest differences between annuities and IRAs is their purpose. An annuity is meant to offer a steady stream of reliable income during your retirement. An IRA, on the other hand, is simply a tax-advantaged account that allows you to invest and save so that you have a pool of available funds in your retirement.
In other words, an IRA functions more like a savings account for your retirement, whereas annuities operate more like a regular income stream like a job would.
Risks
The key risks associated with each of these accounts are another difference between these accounts. The key risk for IRAs is that the investment risk lies on your shoulders, and if you do not contribute enough into your account, you may end up running out of savings during your retirement.
The key risk for annuities is that inflation can make your fixed payment less useful and a variable annuity may not offer as many earnings as you hoped due to fluctuations in the market.
Cost
The final major difference is cost. As a type of insurance offering, annuities are well-known for being quite costly. Even a simple annuity, which is typically much more affordable than a complex one, can be more expensive than an IRA. IRAs typically come with little to no cost to open, and you can start one with most banks and even online brokers.
Annuity vs. IRA: Which Should You Use?
Both annuities and IRAs can be incredibly useful tools in helping you prepare for retirement. But, you may be wondering which option is better for your needs. Unfortunately, there is no clear-cut answer to this question, and the retirement option that will be best for you will depend on your preferences and the type of retirement you want to have.
Either of these options can help supplement your other retirement funds, like social security payments, and either one can offer you significant tax advantages. The biggest difference between these two retirement savings options is how they are structured. Opting for the option that gives you a structure that you understand the most may be a great way to ensure that you are getting the most out of your selected retirement solution.
Can You Have Both?
The simple answer to this question is yes, you can have both an IRA and an annuity plan. But how does this work? Well, there are many ways for you to have both retirement options, but the most common situations are if you are trying to contribute more money to your retirement than you can with an IRA or you are looking to vary your retirement plan to ensure you can live comfortably.
If you are looking to contribute more than the maximum amount you are allowed to add to an IRA account each year, you may want to have both an IRA and an annuity plan. This allows you to contribute the maximum amount to your IRA account and add anything else you’d like to contribute to your annuity plan.
If you simply want to split your contributions and have a variety of retirement funds, you can also do this by having an IRA and an annuity plan and contributing however much you want to each account.
What If You Change Your Mind?
Maybe you’ve already made your decision about which retirement investment option is right for you, but things did not go to plan, and you realize that the other option may be better suited for your needs. In this situation, you may be wondering if you can switch from one type of retirement investment to the other. Luckily, you can.
Just because you select a particular retirement investment option does not mean that you are stuck with that option forever.
IRA to Annuity
If you decide that an IRA is not the right choice for you, you can easily change your retirement plan into an IRA annuity or transfer your IRA into an annuity account. To do this, you simply need to select what type of annuity you want to set up and select the type of your IRA, so your insurance company knows what type of contract you will have.
Keep in mind that the IRS only allows one IRA rollover per year, no matter how many IRA accounts you may have.
Annuity to IRA
If you start your retirement investment plan with a variable annuity but decide that you’d rather put your investments into an IRA, you may be able to roll your variable annuity over. If you use pre-tax dollars in your annuity, then you would be converting your retirement investment into a traditional IRA. On the other hand, if you used after-tax dollars for your annuity, you would be rolling it over into a Roth IRA.
Conclusion
Both IRAs and annuities can be valuable tools in helping you prepare for retirement. Both allow you to generate tax-advantaged growth in your retirement savings, but they are definitely two separate options. The right option for your financial needs, preferences, and situation may be either an IRA, an annuity, or maybe both.
No matter what retirement savings option you choose, remember, the earlier you can start saving for retirement, the better off you’ll be!
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