Annuities and IRAs

Annuities and IRAs are both retirement-oriented investment entities. Both offer favorable tax treatment to owners. Both subject owners to penalties for premature withdrawals.

Despite these similarities, the two are fundamentally different things. Outlining these differences helps to clarify various issues in retirement investment.

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Superficial Annuity/IRA Similarities

An annuity is an insurance contract in which money is paid to the insurance company to secure future payments by the company to the annuityholder. Those payments typically begin during retirement and last for the lifetime of the holder. An IRA (or Individual Retirement Account) is an account in which a variety of assets may repose. During retirement, the value of the account is distributed to its owner, much as the annuityholder receives retirement income.

The investment gains made within the annuity and the IRA accumulate free of taxation. Both annuity and Roth IRA contributions are made with after-tax income; that is, no tax deduction is given for contributions. Distributions from annuities and traditional IRAs are taxable as ordinary income, although some of the distribution may be exempt from tax in both cases. (If part of the annuity distribution constitutes a return of principal, it is not income and cannot be taxed. All or part of a traditional IRA contribution may not have qualified for a tax deduction; if so, it will not be taxed upon distribution.)

Both annuities and IRAs levy tax penalties of 10% on withdrawals made by owners younger than age 59 ½. In addition, some or all of the income withdrawn will be subject to taxation as ordinary income.

Annuity/IRA Differences – Superficial and Otherwise

The most striking difference between an annuity and an IRA is generic. An annuity is a specific investment product, issued by an insurance company and embodied in contractual form. An IRA is an account, created as a repository for any number of investment products and embodied in statutory language. Indeed, annuities are one of the investment products that can repose in an IRA, although that would be appropriate only in specific circumstances.

Tax-related advantages

Because an annuity is an investment product and an IRA contains investment products, an individual might face a choice between directing investment funds to an annuity or to any of several products contained in an IRA. Generally speaking, the IRA contribution should get preference over the annuity purchase. Both choices carry tax deferral for the investment gains. The IRA, however, gets additional tax benefits – either tax deductibility for the initial contribution (into a traditional IRA) or tax freedom for the ultimate withdrawal of funds (from a Roth IRA). The annuity, in contrast, is purchased with after-tax dollars and investment gains are subject to taxation as ordinary income upon distribution.


Another investment- or accumulation-oriented advantage enjoyed by IRA investments is in expenses. Annuities – particularly variable annuities, the species that is most competitive in yield with IRA investment products – generally incur higher expenses than investment products suitable for IRA allocation. This expense disadvantage can be decisive. The generalization can be overdone, however. Mutual funds, a very common IRA investment product, have widely varying annual costs, depending on company policy, structure, distribution method, and format. It is possible to find low-cost annuities – even variable annuities, which are the high-priced spread in the annuity supermarket.

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Can Annuities and IRAs coexist?

Does this mean that an individual should never own both an annuity and an IRA account, because the IRA investment product(s) would always be preferred to purchase of the annuity? No, IRA investments and annuities can complement each other. IRAs are subject to annual contribution limits – $5,000 for individuals under 50, $6,000 for individuals over 50 and $6,000 combined into traditional and Roth IRAs. There is no limitation on annual annuity purchases. Individuals who have maxed out IRA contributions but still have investment funds available may wish to get the tax deferral of an annuity. High earners often find themselves in this spot. If they are middle-aged and growth-oriented, they often choose variable annuities as their investment vehicle. The intervening years until retirement allow time for the variable annuity’s surrender charges to expire and for equity investments to reach their long-term earning potential. At retirement, the annuityholder can either annuitize or maintain control of the funds and make withdrawals as needed.

Another combination of annuities and IRAs is the charitable gift annuity. An IRA owner withdraws proceeds that are used to purchase an annuity issued by a charity. The difference between the charitable annuity payout and the payout offered by a commercial insurance company is a deductible charitable contribution. There are two potential benefits from this strategy (in addition to fulfillment of the charitable intention) – using the deduction to offset taxes that would otherwise be owed on the IRA withdrawal, and using annuity payments to buy life insurance to benefit heirs. This strategy is a complicated one, requiring that confidence be placed in the financial strength of the charity, and should be undertaken only under the guidance of a qualified professional.

More Complementary Annuity/IRA Strategies

An all-too-common investment advisory abuse has been sale of variable annuities inside IRA accounts. This is unnecessary to secure tax deferral since IRA investments already receive this benefit. The motivation behind this practice is the high sales commissions paid by insurance companies to representatives on IRA sales. A proper conjunction of annuities and IRAs would be conversion of IRA proceeds into an immediate annuity at retirement, done in order to guarantee lifelong income to the IRA holder.

Just as annuities offer more flexibility on money invested, so also do they offer more flexibility with withdrawals than IRAs. Required minimum distributions (RMDs) from IRAs must begin no later than age 70 ½, and a continuing preoccupation of IRA holders is to make that income last a lifetime. Annuities have no minimum distributions and can guarantee lifelong income. This is not an argument for shifting IRA investment to annuities, but for combining the two in sequence. The IRA investment can be chosen for its edge in accumulation, while the funds can be shifted to an annuity in retirement to exploit the annuity’s distributional advantages.


Although annuities and IRAs are both retirement-oriented, they are generically different. An annuity is an investment product, while an IRA is an account that may contain many different investment products, including annuities.

Annuities and IRA investments are sometimes economic substitutes, although IRA products enjoy inherent advantages over annuities in tax-related benefits and expenses. While annuities tend to be inferior as accumulation devices, they have more contribution and distributional flexibility than do IRA investment products. IRAs have maximum allowable annual contributions and minimum required distributions; annuities have neither. Investors can have their cake and eat it by supplementing IRA investments with (variable) annuities once contribution limits have been reached and converting IRA investments to annuities at retirement.

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