When preparing for retirement, securing a nest egg is crucial. Individual retirement annuities and individual retirement accounts (IRAs) may sound similar, but they operate in distinct ways.
This post will delve into how individual retirement annuities function, their pros and cons, and how they compare to IRAs.
Let’s dive in.
Understanding Individual Retirement Annuities
An individual retirement annuity is a financial contract provided by an insurance company. This type of annuity is akin to a traditional IRA, offering tax benefits and allowing contributions to grow for retirement.
Unlike traditional IRAs where you can invest in various assets like stocks, bonds, and mutual funds, individual retirement annuities limit your investment options to fixed or variable annuities.
Fixed annuities ensure guaranteed growth and payouts based on a set interest rate by the insurance company. On the other hand, variable annuities connect your returns to the performance of underlying funds, providing potential for higher returns but also carrying more risk.
Think of an individual retirement annuity as a hybrid of an IRA and a life insurance product. It defers taxes like an IRA while offering the secure income stream associated with annuities.
How Individual Retirement Annuities Operate
Understanding the functionality of individual retirement annuities involves examining two key components: Contributions and payouts.
Contribution Limits
Individual retirement annuities follow the same contribution limits set by the IRS, similar to traditional and Roth IRAs. In 2024, the contribution limit for IRAs, including individual retirement annuities, is $7,000 annually, with an additional $1,000 catch-up contribution allowed for individuals aged 50 or older.
You make regular premium payments to the insurance company managing your individual retirement annuity, similar to contributing to a traditional IRA. The insurance company then invests these contributions based on the type of annuity chosen (fixed or variable).
Payouts
Unlike a traditional IRA where you can access your accumulated funds directly, an individual retirement annuity converts your contributions and investment growth into a stream of income payments.
Individual retirement annuities offer various payout options. You can opt for a lifetime income stream, ensuring payments for your lifetime. Alternatively, you can choose a fixed payout period, guaranteeing income for a specific number of years.
Some annuities provide a death benefit, offering a payout to your beneficiaries. According to the IRS, you or your surviving beneficiaries are the only ones eligible to receive benefits. In other words, you cannot sell your future annuity payments to a third-party company, as with some other annuities.
Key Differences Between IRA and Individual Retirement Annuity
Despite falling under the IRA umbrella, individual retirement accounts and annuities have distinct differences.
- Investment Choices: Traditional and Roth IRAs offer a range of investment options, while individual retirement annuities limit choices to fixed or variable annuities.
- Control: With an IRA, you have full control over your investments, asset allocation, portfolio adjustments, and fund withdrawals, with some limitations. Individual retirement annuities offer less control, especially after converting contributions into an income stream.
- Income Stream: Traditional and Roth IRAs do not guarantee a steady retirement income. You manage your funds directly, and the income received depends on your withdrawal management. In contrast, individual retirement annuities offer a secure income stream, akin to a pension, guaranteed by the issuing life insurance company.
Advantages of Individual Retirement Annuities
Individual retirement annuities come with several benefits that can be advantageous for retirement planning.
- Guaranteed Income: The primary benefit is the guaranteed income stream. Unlike traditional IRAs that require self-management, individual retirement annuities transfer the responsibility of management and withdrawals to the insurance company.
- Tax Advantages: Similar to traditional and Roth IRAs, individual retirement annuities come in qualified and non-qualified types. Qualified annuities allow you to deduct contributions from taxable income in the contribution year, while withdrawals are taxed as ordinary income in retirement. Non-qualified annuities do not offer an upfront tax break on contributions, but withdrawals in retirement are tax-free.
- Death Benefit: Some individual retirement annuities include a death benefit, providing a payout to beneficiaries, typically a spouse, in the event of your passing.
Drawbacks of Individual Retirement Annuities
While individual retirement annuities offer benefits, they are not suitable for everyone, and understanding their drawbacks is essential.
- Limited Investment Options: Compared to the flexibility of IRAs, individual retirement annuities restrict investment choices to fixed or variable annuities. If you prefer a hands-on approach to managing your retirement portfolio or have a higher risk tolerance, an individual retirement annuity may not be the best fit.
- Fees: Individual retirement annuities typically come with higher fees than traditional IRAs. These fees can include mortality and expense fees, surrender charges (penalties for early withdrawal), and administrative fees, which can accumulate and impact returns over time.
- Less Liquidity: Once contributions are converted into an income stream, accessing funds may be challenging. This lack of access may not meet emergency liquidity needs.
- Tax Implications: While contributions to traditional individual retirement annuities may be tax-deferred, taxes will eventually be due, with withdrawals and distributions in retirement taxed as ordinary income. Traditional retirement annuities are also subject to required minimum distributions starting at age 73.
- Sensitivity to Inflation: Fixed annuities may not keep pace with inflation over time. While some offer cost-of-living adjustments, these may not fully offset rising prices, potentially reducing purchasing power over time.
Who Should Consider Individual Retirement Annuities?
Individual retirement annuities may suit some individuals but not others.
If you prioritize security and guaranteed income over potentially higher returns, these products may be suitable. Likewise, if you are concerned about outliving retirement savings, individual retirement annuities with lifetime income options can offer a safety net.
Acquiring an Individual Retirement Annuity
If considering an annuity, conduct thorough research first. Familiarize yourself with fixed and variable individual retirement annuities and comprehend associated fees.
Do not settle for the first annuity you encounter. Compare contracts and quotes from multiple insurers, focusing on fees, payout choices, and surrender charges.
While not mandatory, consulting a qualified financial advisor is advisable before proceeding. An advisor can evaluate your specific needs and risk tolerance, helping you determine if an individual retirement annuity aligns with your goals.
Final Thoughts
Individual retirement annuities offer a unique combination of tax benefits and guaranteed retirement income. However, they offer only two investment options, higher fees, and less liquidity than traditional IRAs. Carefully assess your circumstances and retirement objectives before making investment decisions.