Annuity vs. IRA: What’s the difference?
Both help you save for retirement, but each has pros and cons
Saving for retirement can be overwhelming, with so many options to choose from. Two potential tools you can use are annuities and individual retirement accounts (IRAs).
With an annuity, you receive guaranteed payments in the future. You can use annuities for many purposes, such as funding your retirement or ensuring your loved ones are cared for after your death.
IRAs are specifically designed to help you save for retirement. Unlike a 401(k), you own an IRA and can keep contributing to it even if you change employers. Plus, you can receive tax advantages when you use an IRA.
Key insights
- An annuity is an insurance contract to receive guaranteed payments in the future.
- An IRA is an investment to save money for retirement and carries tax advantages.
- Annuities have higher fees than IRAs but more features, like death benefits and long-term care options.
- IRAs offer more tax advantages, but the amount you can contribute each year is low, at a maximum of $6,500 to $7,500.
What is an annuity?
An annuity is an insurance contract where an agent agrees to make guaranteed payments to you in the future. You can purchase an annuity by making a single lump-sum payment or multiple payments over time. The payouts received from an annuity can be in the form of regular payments or one amount.
A fully funded annuity enables you to “receive regular payments, usually over a period of years or for the rest of your life,” explained Michael Collins, CEO of WinCap Financial and a professor at Endicott College.
If you invest in other types of assets, like stocks or bonds, your returns and payouts aren’t guaranteed. An annuity is different because “[t]he general purpose of an annuity is to provide some sort of guarantee,” said Steven Gilbert, the founder of Gilbert Wealth.
The specific guarantees you receive can vary. For example, Gilbert explained that annuities “can include access to lifetime payments, joint life payments, guaranteed term payments, and even death benefits or long-term care benefits.”
Types of annuities
There are three common types of annuities to consider: fixed, variable and equity-indexed.
- Fixed annuities: The contract specifies fixed interest rates and fixed future payout amounts. This is a very predictable type of annuity, as you’ll receive a guaranteed rate of return and future payments.
- Variable annuities: Your rate of return and future payout will vary based on how well the investments tied to the annuity perform.
- Equity-indexed annuities: This combines the features of the other two. Part of the rate of return is fixed, with the remainder tied to an index, like the stock market.
What to consider with an annuity
As you’re deciding how you want your annuity to be structured, Gilbert said it’s important to “review what role the annuity will play in your overall investment plan and financial goals.”
Some factors to consider are below.
Inflation risk
The other types of annuities can mitigate some of this risk, since your rate of return and payouts are partially tied to the underlying investments.
Tax implications
Why the annuity is needed
Collin Plume, the CEO of Noble Gold Investments, explained that annuities are “popular among parents who are bequeathing money to their kids or high earners like celebrities who want to make sure they can invest now to guarantee a secure future when they are past their prime.”
Fees
- Commissions and annual fees to cover administrative costs
- Fees for special features or benefits, like long-term care insurance
- Fees related to the risk of your account (e.g., your risk of death)
The fees you’ll pay on an annuity vary based on the type of annuity you choose. For instance, you might pay commissions of 1% to 10% of the annuity value, along with other costs and fees. As a general rule, the more complicated the annuity, the more you’ll pay in fees. Do your homework to understand how much the annuity will cost you before investing.
» MORE: What is a good investment?
Annuity pros and cons
While annuities can offer a number of benefits, they also have their drawbacks, especially compared with other retirement-saving options.
Pros
- Potential for a guaranteed future payment stream
- Can be structured to provide a death benefit to your loved ones
- Can provide long-term care payouts for you later in life
Cons
- You may be locked into a lower-than-market rate of return with a fixed annuity
- Annuities often carry higher fees than IRAs
- IRAs have multiple tax benefits, while annuities don’t
What is an IRA?
An IRA is an investment you can use to save money for retirement and receive some tax advantages, such as deferred taxes. Unlike a 401(k), which is an employer-sponsored retirement plan, you own your IRA and can continue contributing to it even if you change employers. You can get IRAs from banks, insurance companies and online financial institutions.
Gilbert explained: “An IRA is simply an account type with tax benefits. Within an IRA, you can own a wide variety of investments, including stocks, bonds, mutual funds, exchange-traded funds, options, gold and even annuities!”
Types of IRAs
Two common types of IRAs you can get include:
- Traditional IRA: With this type of IRA, you can deduct some or all of what you contribute each year from your income taxes and may even receive a tax credit equivalent to the percentage you contributed. You generally won’t pay any taxes on your IRA money until you withdraw it from the account.
- Roth IRA: Your contributions to a Roth IRA are not tax deductible but are made post-tax. However, since you already paid taxes on your contributions, you won’t have to pay taxes on your contributions once you start taking qualified distributions at retirement age (at least 59½).
What to consider with an IRA
Since you can choose the investments to put in your IRA, the rate of return you earn will vary. This is a key risk to an IRA.
Other factors to consider include those listed below.
Contribution limits
So, when deciding if an IRA is right for you, consider how much you want to contribute to the investment each year.
Tax implications
“Investments within an IRA grow tax-deferred,” explained Gilbert. “Whenever you make a withdrawal from an IRA, the withdrawal is taxed at your ordinary income tax rates regardless of how the investments would have normally been taxed otherwise.”
You may need to pay additional taxes if you take distributions from an IRA before you reach 59½ years of age. Plus, you might have to pay excise taxes if you don’t start taking minimum distributions after you turn 72. Even so, you’ll often pay fewer fees with an IRA than with an annuity.IRA pros and cons
When it comes to retirement savings, IRAs are a popular choice for many people. They have several benefits, but, like any investment, also have drawbacks.
Pros
- IRAs typically carry lower fees than annuities
- Offered by many banks and insurance companies
- Tax advantages, like pre-tax contributions and tax deferrals
Cons
- Your rate of return is tied to the underlying investment and may vary
- Low annual contribution limits, so you may need to pair it with other savings options
- Additional taxes for early withdrawals or if you don’t start withdrawing money on time
Which should you choose?
Choosing between an annuity and an IRA is a personal decision that varies based on a number of factors, such as:
- Your finances
- Your risk appetite
- Your financial goals
- When or how you want to access your funds
IRAs are good for those who want to prepare for retirement, and annuities provide a way to guarantee an income stream. Depending on your needs, you might want to consider both.
“Both (IRAs and annuities) are good investments and serve different purposes. If you can afford to have both, there is no reason you shouldn’t,” said Plume. “With an annuity, you don’t have to wait for retirement to get a monthly payout. So you can get an annuity while you wait for your IRA liquidation to start.”
If you only opt for one, some other considerations are the characteristics and fees and tax implications of each.
Characteristics
“The main difference between an IRA and an annuity is that an IRA can offer more upside growth potential, since it includes many different types of investments, like stocks, mutual funds and bonds,” explained Charles Claver, director of investment management and trust for First Bank.
“Alternatively, an annuity is an option that guarantees income, thus protection from losses in the stock market that can experience increased volatility. In short, the fundamental benefit of an annuity is an income stream that can't be outlived, so you give up a potentially higher return in exchange for guaranteed income.”
Fees and taxes
“When choosing between annuities and an IRA, it is important to consider any fees associated with each option. Annuities typically come with fees like mortality fees, administrative charges and surrender charges,” said Collins.
“IRAs have fees too, though they typically aren't as high as annuity fees. Additionally, it is important to consider the tax implications of each option.”
He added: “Annuities can be structured in different ways, so it is important to understand the tax implications of each one. With an IRA, the contributions are typically tax deductible, and the withdrawals are taxed as income.”
» MORE: How much do I need to retire?
FAQ
Is an IRA the same as a 401(k)?
No, an IRA is different from a 401(k). Unlike a 401(k), which is an employer-sponsored retirement plan, an IRA is an individual retirement account you own. Since you’re the owner, you can keep contributing to it even if you change employers, whereas you can only contribute to a 401(k) while employed by the company that sponsors it.
Is an annuity the same as a life insurance policy?
Although an annuity is a product commonly sold by life insurance companies, it’s not the same as a life insurance policy. An annuity is an insurance contract allowing you to contribute a single amount or series of payments in exchange for future payouts, like guaranteed lifetime payments at retirement. A life insurance policy instead protects beneficiaries from losses after death by providing them with an agreed-upon payout of money.
At what age should you start an IRA?
You can start an IRA at any age if you earn income. The amount you can contribute to an IRA in 2023 can’t be more than $6,500 if you’re under 50 or $7,500 if you’re 50 or older. You can only contribute the amount of your taxable compensation each year, so you can’t use an IRA unless you’re earning income.
An investment or financial advisor can help you create a plan that’s right for you. Consider how you plan to fund it and when you want to receive payouts. Make sure to start the annuity early enough that you’re able to receive the payouts you need by the time you retire.
How much should you contribute to an IRA?
The amount of money you should contribute to an IRA depends on your financial situation and goals. For 2023, annual IRA contributions are limited to the lesser of your taxable compensation or $6,500 if you’re younger than 50 and $7,500 if you’re 50 or older. Consider your annual income and financial goals when evaluating how much to contribute, and consult with a financial advisor if you’re unsure what’s right for you.
How much money can you put into an annuity?
There are no limits to the amount of money you can put into an annuity; this decision depends on your financial situation, goals and needs. For example, if your goal is to have a guaranteed payout at retirement, you’ll need to contribute enough money to achieve that. A financial advisor can help you identify your goals and develop a plan for how to achieve them.
Bottom line
Annuities and IRAs serve different purposes. IRAs were created to allow people to save for retirement in an account they own and can keep contributing to even if they go between jobs. Annuities are insurance contracts allowing you to save money and receive guaranteed payments in the future for retirement or virtually any other purpose.
The right one for you will depend upon your financial situation and goals. An IRA might be right if you simply want to save a little extra money for retirement and receive tax advantages. You might consider an annuity if you want a guaranteed future payment stream for yourself or your heirs.
If you’re unsure which is right, a financial or investment advisor is a great place to get help.
Article sources
- Annuity.org, " Annuity Fees and Commissions ." Accessed April 24, 2023.
- Insurance Information Institute, " How much should I invest in an annuity? " Accessed March 24, 2023.
- IRS, " Retirement Topics - IRA Contribution Limits ." Accessed March 24, 2023.
- IRS, " Topic No. 451, Individual Retirement Arrangements (IRAs) ." Accessed March 24, 2023.
- Internal Revenue Service (IRS), " Traditional and Roth IRAs ." Accessed March 24, 2023.
- U.S. Securities and Exchange Commission, " Annuities ." Accessed March 24, 2023.
