Key Takeaways
- An annuity is a customizable financial contract sold by an insurance company.
- A traditional IRA is an investment vehicle that can house an array of assets, including stocks, bonds, fund-style vehicles and annuities.
- Annuities and traditional IRAs are both designed to help investors grow their retirement savings in a tax-deferred manner, but they have unique structural designs, advantages and disadvantages.
Introduction
Given the array of financial products in the market, it can be overwhelming trying to determine the appropriate instruments to utilize when saving for retirement. The problem is magnified for the roughly half of Americans who do not have access to work-sponsored retirement plans.
Annuities and traditional individual retirement accounts (IRAs) are two tools that can help these individuals save for retirement in a tax-advantaged manner. This guide highlights the finer points of these vehicles and compares their features.
If you’ve already maxed out your contributions to retirement plans and IRAs, then annuities offer you the chance to invest additional funds that can grow on a tax-deferred basis.
Brandon Renfro, Ph.D., CFP®, RICP®, EACo-Owner of Belonging Wealth ManagementAs a Certified Financial Planner™ professional and Retired Income Certified Professional®, Brandon Renfro is well-versed in the financial information and strategies needed to meet retirement goals. In addition to co-owning Belonging Wealth Management and assisting clients, Brandon writes regularly for financial publications.
How Do Annuities Differ From Traditional IRAs?
An annuity is a financial contract between an insurance company and an individual. It can be structured to reflect varying degrees of risk and may include optional features, known as annuity riders.
Depending on the circumstances, the contract may be purchased with pre-tax dollars or after-tax dollars, which determines whether it is classified as a qualified or non-qualified annuity. The money invested in both types of annuities is permitted to grow on a tax-deferred basis.
However, when funds are withdrawn in retirement, qualified annuities are taxed differently than non-qualified annuities. For qualified annuities, all money withdrawn is taxable. Conversely, for non-qualified annuities, only the earnings portion of money withdrawn is usually taxable.
A traditional IRA is an investment account that allows for tax deductible contributions (up to permissible annual amounts) and tax-deferred growth. These accounts can hold a variety of assets, which gives investors the flexibility to ensure their retirement holdings reflect their investment objectives and tolerance for risk. Like qualified annuities, amounts withdrawn from a traditional IRA account are fully taxable.
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Annuities Held Within Traditional IRAs
As noted above, traditional IRAs are not investment products in and of themselves. They are retirement accounts that can hold a variety of financial securities, including stocks, bonds, mutual funds and exchange-traded funds.
Traditional IRAs can also hold annuities; however, putting an annuity inside of a traditional IRA is not the most tax-efficient way to invest. Annuities and traditional IRAs receive the same tax-deferred treatment, and by putting an annuity inside of a traditional IRA, you are likely forgoing the opportunity to extend your tax advantages.
The smarter long-term strategy is to utilize a traditional IRA to invest in bonds, stocks and fund-style vehicles on a pre-tax basis – up to permissible contribution limits. Then, utilize a standalone annuity to invest excess savings on an after-tax basis. This approach will give you the most “bang for your buck.”
That said, if you value the safety of annuities and want to shift some of your traditional retirement savings into these products, there is a strategy available to you.
How To Roll a Traditional IRA Into an Annuity
For investors looking to put more of their money into annuities, a qualified longevity annuity contract (QLAC) transfer is a sound option. When properly executed, these rollover transactions are not subject to tax and allow you to defer the Internal Revenue Service’s (IRS) required minimum distributions (RMDs) from age 73 to age 85 – a huge benefit, assuming you have ample liquidity to meet your spending needs.
The IRS allows individuals who have a conventional qualified retirement plan (e.g., 401(k), 403(b) or IRA) to utilize their retirement funds for acquiring a Qualified Longevity Annuity Contract (QLAC); however, the purchase limit is capped at $200,000.
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Frequently Asked Questions About Annuities and Traditional IRAs
At a high level, there are three types of annuities – fixed, indexed and variable. Fixed annuities are the safest type of instrument, offering a guaranteed rate of interest. Indexed annuities are a little riskier, with fluctuating returns and downside protection. Variable annuities are the riskiest type of annuity, because they entail investment positions in volatile assets, such as stocks and bonds.
Investing in an annuity is a highly personal decision that depends on your investment objectives and tolerance for risk. Generally, annuities are sensible for conservative investors that have ample near-term liquidity and want to create a hands-off stream of income in retirement.
An IRA is not an investment. Rather, it is a tax-advantaged retirement account that houses various types of assets, including stocks, bonds, fund-style vehicles and annuities.
According to the IRS, the annual contribution limit for traditional IRAs for the 2024 tax year is the lesser of the following amounts:
• $7,000 ($8,000 if you are age 50 or older)
• Taxable earned income for the year
Additionally, the deductibility of your traditional IRA contributions depends on whether you and your spouse participate in work-sponsored retirement plans and how much income each of you earn. Deductibility can be completely phased out for high-income earners that have access to work-sponsored plans.
A Roth IRA is a unique type of tax-advantaged retirement account. It provides the potential for tax-exempt growth of savings, but, unlike a traditional IRA, does not provide any upfront tax deductions.
In retirement, as you withdraw money from a Roth IRA, income taxes are never levied. This contrasts with the fully taxable nature of withdrawals from a traditional IRA.
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