Annuity vs. IRA: what’s the difference?
Planning for retirement can often be a difficult and confusing process. Complex products and financial jargon make what should be a simple business seem downright crooked. Many investors turn to annuities and IRAs for retirement planning. Let’s take a look at some of the main advantages and differences between these two popular options.
What is an IRA?
An IRA, or individual retirement account, is a structure that allows for tax-efficient growth. It’s kind of like wrapping around assets that protects them from paying taxes for a period of time, or forever in the case of a Roth IRA.
IRAs are a great way to save for retirement beyond traditional work plans such as 401 (k) s. You will have more options on what you can invest in with an IRA, such as individual stocks and a much broader offering of mutual funds and ETFs.
Two basic types of ARI
You have two options when it comes to IRAs:
- Traditional IRA: A traditional IRA can give you tax relief on the contributions you make to the account. Contributions will increase tax free, but withdrawals will be fully taxed as ordinary income. You can start withdrawing without penalty at age 59.5, but you don’t have to make withdrawals until age 72.
- Roth IRA: The main advantage of a Roth IRA is that your withdrawals will be tax free, but you will not get tax relief on contributions. Your assets will be able to grow tax-free in a Roth IRA, but you will not be required to make withdrawals at any time. Withdrawals before the age of 59.5 will generally be subject to earnings taxes and a 10% penalty.
What is an annuity?
An annuity is an insurance contract designed to provide investors with regular income during retirement. Similar to an IRA, it has some tax advantages, in that the money invested in an annuity increases tax-deferred until you start receiving payments.
But an annuity is an asset you can invest in, while an IRA is a tax-efficient structure that you can use to invest in assets like stocks, bonds, or ETFs.
How an annuity works
Like any insurance product, you will pay premiums in exchange for the protection provided by the insurer, which in this case is the income stream that the annuity pays you. Depending on the annuity, you can choose to pay the premium all at once or gradually over time. You will also be able to choose when the payments will start, their duration and whether they will continue to be paid to your spouse or partner after your death.
Types of annuities
Annuities come in a few basic varieties, although they can be adapted in a number of ways:
- Fixed: You will receive a fixed payment from the insurance company. It may sound appealing, but remember that inflation can eat away at fixed amounts over time.
- Variable: Your payments will be linked to the investment performance of the funds in which your premium is invested.
- Indexed to equities: This annuity will combine the characteristics of fixed and variable annuities. A portion of the annuity will be linked to the performance of an index such as the S&P 500, but will also have guaranteed minimum payments.
The great thing about annuities is that they can be customized to suit your needs. A popular feature that some people like to add to annuities is a death benefit that works the same way as life insurance and is paid to your beneficiaries upon your death. Be aware, however, that the more features you add to your annuity, the more expensive it will be.
Things to watch out for
Annuities can be complex at times, so make sure you understand what you’re getting before you buy one. Annuities can sometimes come with large commissions for the seller of the insurance company, so consider consulting an independent financial advisor to make sure an annuity is right for your long-term financial goals.
IRAs can generally be opened for little or no charge from various online brokers such as Schwab or Vanguard. However, the assets you choose to put in an IRA can incur fees, so make sure you understand the expense ratio of any mutual funds or ETFs you decide to invest in.
Summary: Annuity vs IRA
Annuities are designed to provide you with regular income during retirement and possibly until your death. IRAs are tax-efficient accounts that allow you to save and invest so that you have a larger nest egg to rely on during retirement.
IRAs and annuities offer tax advantages to investors. Annuities allow tax-deferred growth until withdrawals begin, in which case you will only owe tax on the income in the account as long as you contribute in after-tax dollars.
Traditional IRAs also allow tax-deferred growth until withdrawals begin, which can begin at age 59 and a half. Roth IRAs offer account owners the benefit of tax-free growth as well as tax-free withdrawals.
Annuities are known for the large sales commission paid on the purchase to the relevant seller. You could pay a fee of up to 10 percent on the amount invested before you see any growth or payments. Simple annuities are generally less expensive than complex annuities.
On the other hand, IRAs are generally offered inexpensively or even at no cost, and can be opened through most online brokers.
For annuities, the main risks include inflation which eats away at a fixed dollar payment and variable annuities which may be insufficient due to market fluctuations.
For IRAs, the investment risk is yours and if you don’t contribute enough during your working years or invest it wisely, you may not have enough to live comfortably in your retirement.
At the end of the line
While IRAs and annuities can offer investors the opportunity for tax-efficient growth, they really should be viewed as two separate retirement options. An IRA is an account structure in which you place assets to protect them from taxes, while an annuity is an insurance contract designed to provide you with stable income during retirement.