Annuity vs. IRA: Is One the Smarter Choice for Retirement?

Individual retirement accounts and annuities are both vehicles for saving for retirement and for producing income in retirement. There are differences and benefits to both options. The best option for your situation will depend on your needs and unique circumstances.

Here’s what you need to know about annuities versus IRAs so you can create the smartest retirement plan to meet your financial goals.

Annuity vs. IRA: The basics

An annuity and an IRA are both ways to save for retirement. Beyond that, annuities and IRAs are two completely different things.

An IRA is a type of tax-advantaged account opened for the purpose of investing money to help the account holder save for retirement. IRA accounts generally offer a wide range of investment options that are limited only by what is available through the account custodian or prohibited by the rules governing IRA accounts. An annuity can be held inside of an IRA account, though this is usually not a good idea.

An annuity, on the other hand, is a form of guaranteed income based on an insurance contract. There are several types of annuities, but in all cases, the premiums or contributions paid into the annuity fund the contract. The premiums plus any growth within the account determine the future value available to withdraw. Most contracts offer several options as far as withdrawing the money that has accumulated.

Let’s break both of these retirement strategies down in more detail.

How does an annuity work?

Annuities are issued and sold by insurance companies, though an annuity is not an insurance policy. They are contracts between the annuity purchaser and the insurance company that essentially convert the lump sum of your premiums into a future source of income. The attraction of annuities is that they offer a stream of income that may not be outlived depending on the annuitization option chosen. There are a number of annuitization and distribution options that can be chosen, as well as a number of different types of annuities that insurers offer.

Annuitization

Annuitization refers to taking your money from the contract on a regular basis, usually monthly. It can be set up in a number of ways:

• Lifetime: Payments will continue as long as the account holder is alive. This could also be called a single life or life-only annuity. The payments stop when the annuitant dies. If they annuitize and die a month later, that’s the end of the payment stream.
• Joint and survivor: If one person dies, the annuity will continue for the life of the survivor. This is a common option for a married couple.
• Period certain: Payments occur for a specific period of time. If the account holder dies within this time, the payments continue for the rest of the period to one or more designated beneficiaries.
• Life and period certain: An example of this might be life and 20-year period certain. Payments are made for the lifetime of the annuitant (even if they live beyond 20 years) If they die prior to that time, their beneficiaries are paid out for the remainder of the 20-year term.

Types of annuities

One of the first choices you’ll make when it comes to an annuity is whether it is variable or fixed:

• Variable annuities allow the contract holder to invest their premium dollars in subaccounts that operate much like mutual funds. You may even be able to choose a subaccount based on a particular goal. Contributions to the annuity can grow based on how well the money invested in the various sub accounts performs.
• Fixed annuities pay a set level of interest on the premiums contributed. This amount accumulates over time until the contract owner commences payouts from the contract.
• Indexed annuities are also sometimes called equity-indexed annuities. These offer returns tied to some external index like the S&P 500. Typically the maximum return is capped at some percentage of the index’s return. There is often also a minimum interest rate that you will earn.

You will also be able to choose which type of annuity payment schedule you’d like:

• Immediate annuities begin payments to the person shortly after they make a premium deposit into the annuity. If you pay in monthly, you may only have to wait one month to receive payment.
• Deferred annuities don’t begin paying out immediately, but rather at a later date specified by the contract holder.

Fees and expenses

Annuity fees and expenses can be high and complex in many cases. There are generally internal costs, similar to the expense ratio on products such as mutual funds, which reduce the net return on the money invested.

Annuities might also carry a surrender charge that kicks in if you try to withdraw from the annuity or transfer it to another product within a set period of time. You might see surrender periods as long as 15 years. This fee usually decreases over time.

The expenses on an annuity can vary greatly by annuity provider and the type of annuity. Typically the more complex the annuity, the higher the fees. In addition, the agent managing your annuity will typically be paid by commission and how much they earn will be based on a percentage of your deposited funds.

Tax implications of an annuity

A qualified annuity is one that is funded with pre-tax dollars and typically held inside of an IRA or 401(k). In these cases, your withdrawals will be subject to taxation as income.

A non-qualified annuity is one where the premium payments are made with after-tax dollars. This type of annuity is part taxable and part tax-deferred. You typically don’t pay tax on the premium amount, but you do pay taxes on the gains that have accrued. How your exact amount of taxes is calculated is based on something known as an exclusion ratio, and you may want to have a tax accountant assist you with this.

Pros and cons of annuities

Pros

• Annuities can provide a steam of guaranteed lifetime income
• Annuities are taxed only upon the withdrawal of funds
• Money inside the annuity can grow on a tax-deferred basis over time

Cons

• Many annuities have high expenses and fees
• If you decide you want your money back quickly, you may pay surrender charges
• Annuities can be very complex and hard to understand.

How does an IRA work?

An IRA is a retirement account that can be opened with a brokerage firm, many mutual fund companies, banks, and even with most robo-advisors. Account holders can put their money in most types of investment vehicles including mutual funds, exchange-traded funds, individual stocks, and bonds among others. Many people choose these accounts because of the ability to strategize the tax benefits.

In order to contribute to an IRA account you must have earned income from employment or self-employment equal to or greater than the amount of your contributions.

There are two types of IRA accounts:

• Traditional IRA: Contributions can be made with pre-tax or after tax dollars, but are generally made pre-tax. Earnings in the account grow tax-deferred. Withdrawals are fully taxable, except the amount equal to any after-tax contributions. Withdrawals prior to age 59 1/2 are subject to a 10% early withdrawal penalty, with a few exceptions.
• Roth IRA: Contributions are made with after-tax dollars. Money grows tax-free inside of the account and can be withdrawn tax-free as long as certain rules are followed. Early withdrawals prior to age 59 1/2 may be subject to taxes and a 10% penalty in some cases.

For the tax year 2024, the annual contribution limits for an IRA are $7,000 plus an extra $1,000 in catch-up contributions for those 50 or over. For the tax year 2025, the annual contribution limits for an IRA are $7,000 plus an extra $1,000 in catch-up contributions for those 50 or over. These are total IRA contributions; there aren’t separate limits for traditional and Roth accounts.

The ability to contribute to a Roth IRA is limited if your income is above certain limits, as is the ability to make pre-tax contributions to a traditional IRA if you are covered by a 401(k) or similar workplace retirement plan. On the plus side, you may have the ability to do a 401(k) to IRA rollover.

Pros and cons of IRAs

Pros

• The ability to invest in a wide range of investment options
• Tax-deferred or tax-free growth
• Anyone with earned income can contribute
• Money can be rolled over from retirement plans like a 401(k)

Cons

• Relatively low annual contribution rates
• Traditional IRAs are subject to required minimum distributions (RMDs)
• Income limitations apply to Roth IRAs and to pre-tax traditional IRA contributions

Annuity vs. IRA: How to decide which is right for you

An IRA might be better for those who are comfortable managing their investments or who work with a financial advisor who does this. IRAs are ideal for those with 401(k) money to roll over as well.

An annuity is a good solution if you are someone who is looking to create a pension-like stream of income starting at a certain point in the future and lasting for the rest of your life.

But this is not necessarily an either or situation, investors can have both an IRA and an annuity if this makes the most sense for their situation. It’s good to consider your life as a future retiree and your current personal finance situation when making your decisions.

FAQs

Bottom line

IRAs are a type of retirement account that allows account holders to put their money into a wide range of investment vehicles while also enjoying certain tax advantages. But their contributions are limited based on annual caps, though money can be rolled over from a 401(k) or other type of retirement account.

Annuities are an insurance product that can provide guaranteed lifetime income. Annuities can be very complex and expensive, so it's important to choose wisely before investing your money in an annuity contract.

If you aren’t sure which product is for you, or if you might want to put money into both, then you might consider speaking with a financial advisor who has the ability to discuss retirement planning and tax planning with you.