In the world of retirement planning, annuities and IRAs are financial instruments used to provide users with future income. But these pension products are very different.
An annuity and an IRA can both help you save money for retirement. You can defer taxes on money that appreciates in the account, so that you don’t have to pay taxes until you withdraw money (for an IRA) or start receiving payments (for annuities). But that’s where their similarities end.
An IRA is an investment account, while an annuity is a contract between you and a life insurance company. These financial products function in fundamentally different ways, so it is important to understand their purpose, costs and other features.
Let’s take a look at some of the key benefits and differences between these two retirement options.
What is an IRA?
An IRA, or individual retirement account, is an investment account that allows for tax-advantaged growth. It’s a kind of wrapper you put around assets and protects them from paying taxes for a specified period of time, or forever in the case of a Roth IRA.
IRAs are a great way to save for retirement, in addition to traditional workplace plans like 401(k)s. An IRA puts the investment decisions in your hands. You can choose from a range of investments, including stocks, bonds, mutual funds, ETFs and more. You can build your portfolio yourself or use a robo-advisor to create one for you. You can open an IRA with many of the top brokers with no account minimums or trading fees.
You gain more control over your investments, returns and costs. But with that control comes responsibility. If you don’t contribute enough or deplete your IRA to cover expenses while you work, you may not have enough money to retire.
Two Basic Types of IRAs
You have two options when it comes to IRAs:
- Traditional IRA: With a traditional IRA, you may be able to receive a tax benefit on the contributions you make to the account. Contributions will grow tax-free, but withdrawals will be fully taxed as ordinary income. You can start withdrawing without penalty from the age of 59.5, but you are not obliged to withdraw money until the age of 73.
- Roth IRA: The main benefit of a Roth IRA is that your withdrawals are tax-free, but you don’t receive a tax benefit on contributions. Your assets are allowed to grow tax-free within a Roth IRA, but you don’t have to withdraw money at any time. Withdrawals before age 59½ are generally taxed on any gains and subject to a 10 percent penalty.
What is an annuity?
An annuity is an insurance contract designed to provide buyers with a steady stream of income during retirement. Like an IRA, money invested in an annuity grows tax deferred until you begin receiving payments.
How an annuity works
With an annuity, you pay a premium to a life insurer to protect you against the risk of running out of money after retirement. You finance the annuity contract and the insurer promises to pay you a series of benefits now or in the future, for however long you choose.
Depending on the annuity, you can choose to pay the premium in one go or spread it out. You can also choose when the benefits will start, how long they will last and whether they will continue to be paid to your spouse or partner after your death.
The trade-off? It generally takes a lot of money to fund an annuity (think $100,000 and up). You also give up a certain degree of control over your money when you enter into an annuity contract. Returns can be mediocre, fixed payments can’t keep up with inflation, and hidden fees and sales commissions are often baked into the contract.
Types of annuities
There are different types of annuities, and each type can be customized in different ways:
- Fixed: You will receive a fixed compensation from the insurer. This may sound appealing, but remember that inflation can eat away at fixed dollar amounts over time.
- Variable: Your payments depend on the investment performance of the funds in which your premium is invested. This option may be beneficial for those who don’t mind fluctuating performance in their retirement accounts and higher compensation.
- Share indexed: This annuity combines features of fixed and variable annuities. Part of the annuity will be tied to the performance of an index such as the S&P 500, but will also have guaranteed minimum payments.
The appeal of annuities is that they can be tailored to your needs. A popular feature that some people like to add to annuities is a death benefit that functions similarly to life insurance and goes to your beneficiaries upon your death. However, keep in mind that the more participants you add to your annuity, the more expensive it will be.
Things to watch out for
Annuities can be complex, so make sure you understand the terms of your contract before signing over your money. Consider contacting an independent financial advisor to ensure an annuity is right for your long-term financial goals.
IRAs can typically be opened at little or no cost with various online brokers, such as Charles Schwab or Vanguard. However, the assets you place in an IRA may come with fees. So make sure you understand the expense ratio of mutual funds or ETFs in which you decide to invest.
Summary: Annuity vs. IRA
Goal
Annuities are insurance products designed to provide you with a steady stream of income during your retirement and possibly until your death. IRAs are tax-advantaged retirement accounts where you buy and sell your own investments, including stocks, bonds, mutual funds and other securities.
Tax benefits
Both IRAs and annuities offer investors tax benefits. Annuities provide tax-deferred growth until withdrawals begin, at which point you only owe taxes on the account’s earnings as long as you’ve made contributions in after-tax dollars.
Traditional IRAs also allow for tax-deferred growth until withdrawals begin, which can begin at age 59.5. (You’ll face a 10 percent tax penalty if you withdraw before that age.) Roth IRAs give account owners the benefit of tax-free growth and tax-free withdrawals.
Cost
Annuities are notorious for the large commission paid to the seller involved. You can pay a fee of up to 10 percent of the amount invested, and while you may not pay this directly, that commission ultimately comes out of your returns.
Simple annuities are generally cheaper than complex annuities. The details of each contract can vary, so make sure you understand the details surrounding fees and commissions before committing your money.
In addition, most annuities have a surrender period during which you may be charged a penalty if you withdraw your money prematurely, usually the first six to eight years of the account. However, these surrender charges tend to decrease over time.
On the other hand, IRAs typically incur little to no fees and can be opened through most online brokers.
Risks
For annuities, key risks include eating away at a fixed dollar benefit and variable annuities that may fall short due to market fluctuations.
For IRAs, the investment risk is on you. If you don’t contribute enough or invest wisely during your working years, you may not have enough to last you through retirement.
In short
While both IRAs and annuities can offer investors the opportunity for tax-advantaged growth, they should really be viewed as two separate retirement options. An IRA is an account structure into which you place assets to protect them from taxes, while an annuity is an insurance contract designed to provide you with a steady income during retirement.
