Annuity vs. IRA: What’s the difference?

  • By Brian Baker,
  • Bankrate.com
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Retirement planning can often be a challenging and confusing process. Complex products and financial jargon make what should be a simple endeavor seem downright tortuous. Many investors turn to annuities and IRAs to plan for retirement. Let’s look at some of the key 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-advantaged growth. It’s sort of like a wrapper that you put around assets that shields 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 workplace plans such as 401(k)s. You’ll 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 IRAs

You have two options when it comes to IRAs:

  • Traditional IRA: A traditional IRA may allow you to receive a tax break on contributions you make to the account. Contributions will grow tax-free, but withdrawals will be fully taxed as ordinary income. You can start making withdrawals penalty-free at age 59 ½, but aren’t required to take withdrawals until age 72.
  • Roth IRA: The main benefit of a Roth IRA is that your withdrawals will be tax-free, but you won’t receive a tax break on contributions. Your assets will be allowed to grow tax-free inside a Roth IRA, but you won’t be required to make withdrawals at any time. Withdrawals before the age of 59 ½ will typically face taxes on any gains and a penalty of 10 percent.

What is an annuity?

An annuity is an insurance contract designed to provide investors with a steady income stream during their retirement. Similar to an IRA, it has some tax advantages, in that money invested in an annuity grows tax-deferred until you start receiving payments.

But an annuity is an asset you can invest in, while an IRA is a tax-advantaged structure that you can use to invest in assets such as stocks, bonds, or ETFs.

How an annuity works

Like any insurance product, you’ll pay premiums in return for protection the insurer provides, which in this case is the income stream the annuity pays to you. Depending on the annuity, you can choose to pay the premium all at once or gradually over time. You’ll also be able to choose when the payments start, how long they last and whether they’ll continue to be made to your spouse or partner after your death.

Types of annuities

Annuities come in a few basic varieties, though they can be adapted in a variety of ways:

  • Fixed: You’ll receive a fixed payment from the insurance company. This might sound appealing, but remember that inflation can eat away at fixed dollar amounts over time.
  • Variable: Your payments will be tied to investment performance of the funds your premium is invested in.
  • Equity-indexed: This annuity will combine features of fixed and variable annuities. A portion of the annuity will be tied to the performance of an index such as the S&P 500 (.SPX), but will also have guaranteed minimum payments.

Something appealing about annuities is that they can be customized to your needs. One popular feature that some people like to add to annuities is a death benefit that functions similar to life insurance and goes to your beneficiaries upon your death. Be aware though that the more features you add to your annuity, the more costly it will be.

Things to watch out for

Annuities can sometimes be complex, so make sure you understand exactly what you’re getting before buying one. Consider checking with an independent financial advisor to make sure an annuity is right for your long-term financial goals.

IRAs can typically be opened for little or no cost from a variety of online brokers such as Schwab or Vanguard. The assets you choose to put in an IRA can carry fees, however, so make sure you understand the expense ratio of any mutual funds or ETFs you decide to invest in.

Summary: Annuity vs IRA

Purpose

Annuities are designed to provide you with a steady stream of income during retirement and possibly until your death. IRAs are tax-advantaged accounts that allow you to save and invest so that you have a larger nest egg to rely on during retirement.

Tax benefits

Both IRAs and annuities offer tax benefits to investors. Annuities allow for tax-deferred growth until withdrawals begin, at which point you’ll owe taxes on just the account’s earnings as long as you made contributions in after-tax dollars.

Traditional IRAs also allow for tax-deferred growth until withdrawals begin, which can start at age 59 ½. Roth IRAs give the account owners the benefit of tax-free growth as well as tax-free withdrawals.

Costs

Annuities are notorious for the large commission paid to the salesperson involved. You could pay a charge of up to 10 percent on the amount invested, and while you may not pay it directly, that commission ultimately comes out of your returns.

Simple annuities are generally less expensive than complex ones. The specifics of each contract can vary, so make sure you understand the details surrounding fees and commissions before committing your money.

In addition, most annuities come with a surrender period, during which you won’t be able to withdraw more than your payment without incurring a penalty. These surrender charges tend to go down over time.

On the other hand, IRAs typically come with little to no cost and can be opened through most online brokers.

Risks

For annuities, key risks include inflation eating away at a fixed-dollar payment and variable annuities that may fall short due to market fluctuations.

For IRAs, the investing risk lies with you and if you don’t contribute enough during your working years or invest it wisely, you might not have enough to live comfortably during retirement.

Bottom line

While both IRAs and annuities can offer investors the chance for tax-advantaged growth, they should really be thought of as two separate retirement options. An IRA is an account structure that you put assets into to shield them from taxes, while an annuity is an insurance contract designed to give you a steady income during retirement.

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