What's the Difference Between an IRA and an Annuity?

An income gap refers to the difference between the income you need during retirement and the expected income from all retirement assets available (Social Security, 401(k)s, annuities, IRAs, etc.). As more and more people prepare for retirement, concerns grow as an increasing number of those ages 60 and older are set to rely on a single income source for their financial needs.

If you’re looking to replace the majority of your present earnings in retirement, you need to have a plan in place. Funding your retirement income goals also requires education and knowledge about the types of savings vehicles available and how they may be used to assist you in building an adequate retirement nest egg.   

What Is an Individual Retirement Account (IRA)?

It’s likely you have at least a basic understanding of individual retirement accounts (IRAs) and how they work. If you earn any amount of income, you are permitted to contribute to an IRA. The amount you may contribute is the lesser of 100 percent of your earned income or $6,000 (plus an additional $1,000 if you are aged 50 or older).¹  

IRAs were first created as part of the Employee Retirement Income Security Act (ERISA) of 1974, a law passed to address issues regarding retirement savings for employees. As of December 31, 2019, a little more than $11 trillion in assets were held in IRAs, making up more than one-third of all retirement assets in the U.S. ($32.3 trillion).²

There are several different types of IRAs available:

• Traditional IRA: Deduct contributions made, which grow on a tax-deferred basis until withdrawn at retirement (aged 59 ½ or older). Once withdrawn, income is taxable.
• Roth IRA: Permits contributions that are not tax-deductible but when withdrawn produce a tax-free income.
• Rollover IRA: For assets from a qualified retirement account, such as a 401(k), that need a place to be transferred to in order to maintain their tax-advantaged status. 
• Spousal IRA: Although a provision in the law that requires contributions to an IRA be made by individuals with earned income, a non-working spouse may contribute up to the limit of $6,000 (plus $1,000 catch-up provision for age 50 and older) into a spousal IRA.

What Is an Annuity?

Annuities, which are an insurance product designed to meet the risk of living too long (or outliving one’s income in retirement), provide another vehicle for retirement savings. Annuities are issued by insurance companies and are designed to pay income for a limited (e.g. period, period certain) or fixed (e.g. 10-year, 20-year) up to the lifetime of the annuitant.

Annuities contain charges and fees unique to insurance-style products, such as a mortality and expense fee (death benefit charge). An advantage of owning an annuity as opposed to investing in an IRA is the ability to contribute as much to the contract as you like without limit or penalty. All of the payments that you make in an annuity grow on a tax-deferred basis (the same as with a traditional IRA).

There are two distinct periods in an annuity: accumulation, or build-up period where contributions are deposited and grow tax-deferred; and, annuity payout, where a distribution of principal and earnings is made in the form of a stream of income. The size (value) of the annuity at the time of the payout as well as the payment option chosen determines the size of each income payment you receive.

Which Option Is the Best to Choose?

Deciding between the establishment of a traditional or Roth IRA or the purchase of an annuity is not necessarily an either/or choice. Depending on the types of things you have done to save for your retirement (and avoid falling into the retirement income gap), you may decide that investing in an IRA provides you with certain benefits while an annuity may be helpful in handling a large lump-sum deposit or an irregular payment schedule.

The type of vehicle you choose for your retirement savings should align with your savings goals. One way to determine which choice to make is:

• Traditional IRAs are ideal if you are looking for current deductibility of contributions made to the account and tax-deferred growth without regard to any limit on how much you may contribute.
• Roth IRAs are ideal if you seek a tax-free distribution of income at retirement and have no concern for a current tax deduction.
• Annuities are ideal if you are looking for a retirement savings vehicle with no limits to contribution amount and a predictable income stream.

Avoid the pitfalls of retirement savings others make and take advantage of all vehicles available to you. Maximize your contributions to an employer-sponsored plan and look at how an IRA can supplement those savings. An annuity is also an important piece to your retirement planning and can help you reach and fulfill your income goals in retirement.