IRA vs. Annuity: What's the Difference?

IRA vs. Annuity: An Overview

Both individual retirement accounts (IRAs) and annuities provide tax-advantaged ways to save for retirement, but there are distinct differences between the two. For one thing, an IRA is not in itself an asset. Rather, it's a vehicle for holding financial assets—stocks, bonds, mutual funds. In contrast, annuities are assets—specifically insurance products, designed to generate income.

IRAs

An IRA can be thought of as an individual investment and savings account with tax benefits. You open an IRA for yourself (that's why it's called an individual retirement account). If you have a spouse, you'll have to open separate accounts (if one partner earns low or no wages, you can use the family income to open a spousal IRA, to benefit that spouse and double the family's retirement savings options).

Keep in mind that an IRA is not itself an investment. Instead, it is an account in which you keep investments such as stocks, bonds, and mutual funds. Within certain limitations, you get to choose the investments in the account and can change them if you wish.

Your return depends on the performance of the investments held in the IRA. An IRA continues to accumulate contributions and interest until you reach retirement age, meaning you could have an IRA for decades before making any withdrawals.

An IRA usually may carry a small custodial fee, which is charged by the financial institution where your account is held. Of course, mutual funds within the IRA charge their own annual management fees, called expense ratios.

IRA Rules

IRAs are defined and regulated by the Internal Revenue Service (IRS), which sets eligibility requirements as well as limits on how and when you can make contributions and take distributions. The IRS also determines the tax treatment for the various types of IRAs.

There are two main types of IRAs:

• Contributions to traditional IRAs are made with pretax dollars and are deductible for the year in which they are made. Withdrawals are taxed as income.
• Contributions to Roth IRAs are made with after-tax dollars, but withdrawals are not subject to tax.

For 2023, the maximum you can contribute to your traditional or Roth IRA is $6,500 of your taxable income for the year ($7,000 in 2024). You can make an additional catch-up contribution of $1,000 each year (for a total of $7,500 in 2023 and $8,000 in 2024) if you're age 50 or older.

Traditional IRA account holders can start withdrawing funds at age 59½, although the IRS does allow you to take early withdrawals under certain circumstances. If you have a Roth, you can withdraw contributions at any time but will pay a penalty if you withdraw any interest or earnings from investments too early. The early withdrawal penalty for both types of IRAs is 10%.

Annuities

Annuities are insurance products that provide a source of monthly, quarterly, annual, or lump-sum income during retirement. An annuity makes periodic payments for a certain amount of time, or until a specified event occurs (for example, the death of the person who receives the payments). Money invested in an annuity grows tax-deferred until it is withdrawn.

Unlike an IRA, which typically can have only one owner, an annuity can be jointly owned. Annuities also do not have the annual contribution limits and income restrictions that IRAs have. There are a variety of annuities. You can fund an annuity all at once (known as a single premium) or you can pay into it over time.

With an immediate payment annuity (also called an income annuity), fixed payments begin as soon as the investment is made. If you invest in a deferred annuity, the principal you invest grows for a specific period of time until you begin taking withdrawals—usually during retirement. As with IRAs, you will be penalized if you try to withdraw funds from the deferred annuity early before the payout period begins.

Because an annuity is basically an investment instrument inside an insurance policy, fees can be high. You pay fees for the insurance, management fees for the investments, fees if you try to get out of the contract (aka surrender charges), and fees for riders. These are optional additions to the basic contract, such as one that guarantees a minimum increase in annuity payments each year.

Annuity Payments: Fixed or Variable

Both immediate and deferred annuities can dole out their payments at either a fixed or variable rate.

In a fixed annuity, the funds are managed by the financial entity. You have no say in how that money is invested. Once annuitization takes place, a fixed amount is paid to you—either as a lump sum or in payments over several years or your lifetime.

Variable annuities allow you to choose from a menu of investment options. These options could include mutual funds, bond funds, or money-market accounts. One version of a variable annuity, which is called an equity-indexed annuity, tracks a specific stock index such as the S&P 500. Opting for a variable rate holds out the possibility of greater returns, but it also carries greater risk.

A variable annuity is the most comparable to an IRA. Both are essentially tax-sheltered shells that house investment funds. However, variable annuities have higher annual expenses than IRAs do.

Taxes on Annuity Payments

One key question you’re probably asking now is: Are annuity payouts taxable? That depends largely on whether you purchased the annuity with pre-tax or after-tax funds—terms IRA investors know all too well. Essentially, the taxes you pay on an annuity distribution depend on the portion of that distribution that was not taxed initially.

So, if you purchase the annuity with pre-tax money, such as funds from a traditional IRA, all payments are fully taxable. If you buy the annuity with after-tax money, you will not pay taxes on the return of your (already taxed) principal, but you will pay taxes on the earnings.

How you figure which is which can be a little complicated, involving something called the exclusion ratio, which divides your withdrawals over your life expectancy. Your accountant can do the math, or the annuity issuer might send you a year-end statement indicating the principal and earnings portions of the payout.

However, if you use funds from your Roth IRA or a Roth 401(k) to purchase an immediate fixed annuity when you retire, all payments will be tax-free because the source of those funds—your Roth IRA—is tax-free. (You’d still house the annuity within the Roth account.) However, the regular Roth distribution rules apply. You must be over age 59½, and you must have had the account for at least five years.

The same applies to holding a deferred annuity inside your Roth IRA.

Does an Annuity Belong in an IRA?

Should your IRA be invested in an annuity?

As noted above, when you purchase an annuity inside an IRA, the IRS rules for the IRA supersede the rules for the annuity. This means that any detrimental tax treatment of the payments is irrelevant if the annuity resides inside the IRA. The advantage of a steady, guaranteed, tax-free income stream at retirement, however, might well justify putting a portion of your assets into such an annuity.

That’s from the payment standpoint. But from the investment-growth standpoint, things are a little murkier—especially if you’re relatively young (or at least decades from retirement) and buying a deferred annuity. In this case, you would be placing a tax-advantaged instrument (the annuity) inside a tax-sheltered account (the IRA)—which, on its face, doesn’t seem to make a lot of sense.

There’s also the issue of illiquidity. Most annuities carry heavy surrender charges if you decide you want to cash out and invest funds elsewhere. If your annuity is fixed, you have no say in deciding how those funds are invested. If your annuity is variable, the investment options are limited.

And then there’s the fact that annuities are expensive: all those aforementioned fees, which are rather high compared to the annual expense ratios of mutual funds or exchange-traded funds (ETFs). Also, many annuity contracts allow for fee increases by the insurer, something you likely can’t avoid, except at great expense, thanks to those surrender charges.

The Bottom Line

Annuities make sense for some people. For others, they do not. For that reason, investing in an annuity—let alone doing so inside an IRA—should only be done after consulting with a qualified independent financial advisor. There may be other ways to ensure a regular income stream that doesn’t incur such high fees.