Annuity vs. IRA: What’s the difference?

In the world of retirement planning, annuities and individual retirement accounts (IRAs) are financial vehicles used to provide users with future income. But these retirement products are very different.

An annuity and an IRA both let you save money for retirement. You can defer taxes on money that’s appreciated inside the account, so you won’t owe taxes until you withdraw funds (for an IRA) or start receiving payments (for annuities). But that’s where their similarities end.

An IRA is an investment account, while an annuity is a contract between you and a life insurance company. These financial products function in fundamentally different ways, so it’s important to understand their purpose, cost, limitations and other features.

Let’s look at some of the key advantages and differences between these two retirement options.

What is an IRA?

An IRA is an investment account that allows for tax-advantaged growth. It’s sort of like a wrapper that you put around assets that shields them from paying taxes for a period of time (or forever, in the case of a Roth IRA).

IRAs are a great way to save for retirement beyond traditional workplace plans such as 401(k)s. An IRA puts the investment decisions in your hands. You can pick from a range of investments, including stocks, bonds, mutual funds, ETFs and more. You can also build your portfolio yourself, or use a robo-advisor to help create one for you. You can open an IRA through many of the top brokers with no account minimums or trading fees.

You get more control over your investments, returns and costs. But with that control comes responsibility. Fail to contribute enough or drain your IRA to cover expenses when you’re working, and you might not have enough money to last through retirement.

Two basic types of IRAs

You have two options when it comes to IRAs:

• Traditional IRA: A traditional IRA may allow you to receive a tax break on contributions you make to the account. Contributions will grow tax-free, but withdrawals will be fully taxed as ordinary income. You can start making withdrawals penalty-free at age 59 ½, but aren’t required to take withdrawals until age 73.
• Roth IRA: The main benefit of a Roth IRA is that your withdrawals will be tax-free, but you won’t receive a tax break on contributions. Your assets will be allowed to grow tax-free inside a Roth IRA, but you won’t be required to make withdrawals at any time. Withdrawals before the age of 59 ½ will typically face taxes on any gains and a penalty of 10 percent. However, you can withdraw contributions (not earnings and capital appreciation) after five years without penalty.

What is an annuity?

An annuity is an insurance contract designed to provide purchasers with a steady income stream during their retirement. Similar to an IRA,  money invested in an annuity grows tax-deferred until you start receiving payments.

How an annuity works

With an annuity, you pay a premium to a life insurance company to protect you against the risk of running out of money in retirement. You fund the annuity contract and the insurer promises to pay you a series of payments now or in the future, for however long you choose.

Depending on the annuity, you can choose to pay the premium all at once or gradually over time. You’ll also be able to choose when the payments start, how long they last and whether they’ll continue to be made to your spouse or partner after your death.

The trade-off? It generally takes a lot of money to fund an annuity (think $100,000 and up). You also give up a certain amount of control over your money when you sign an annuity contract. Returns can be lackluster, fixed payments might not keep up with inflation, and hidden costs and sales commissions are often baked into the contract.

Types of annuities

There are several types of annuities, and each kind can be adapted in a variety of ways:

• Fixed: You’ll receive a fixed payment from the insurance company. This might sound appealing, but remember that inflation can eat away at fixed dollar amounts over time.
• Variable: Your payments will be tied to the investment performance of the funds your premium is invested in. This option might benefit those who do not mind fluctuating performance in their retirement accounts and higher fees.
• Equity-indexed: This annuity combines features of fixed and variable annuities. A portion of the annuity will be tied to the performance of an index such as the S&P 500. Your upside potential will be capped, but you’ll have downside protection.

Something appealing about annuities is that they can be customized to your needs. One popular feature that some people like to add to annuities is a death benefit that functions similarly to life insurance and goes to your beneficiaries upon your death. Be aware, though, that the more riders you add to your annuity, the more costly it will be.

Things to watch out for

Annuities can be complex, so make sure you understand the terms of your contract before signing over your money. Consider checking with an independent financial advisor to make sure an annuity is right for your long-term financial goals.

IRAs can typically be opened for little or no cost from a variety of online brokers such as Charles Schwab or Vanguard. The assets you choose to put in an IRA can carry fees, however, so make sure you understand the expense ratio of any mutual funds or ETFs you decide to invest in.

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Summary: Annuity vs. IRA

Purpose

Annuities are insurance products designed to provide you with a steady stream of income during retirement and possibly until your death. IRAs are tax-advantaged retirement accounts in which you buy and sell your own investments, which can include stocks, bonds, mutual funds and other securities.

Tax benefits

Both IRAs and annuities offer tax benefits to investors. Annuities allow for tax-deferred growth until withdrawals begin, at which point you’ll owe taxes on just the account’s earnings as long as you made contributions in after-tax dollars.

Traditional IRAs also allow for tax-deferred growth until withdrawals begin, which can start at age 59 ½. (You’ll face a 10 percent tax penalty if you withdraw before that age.) Roth IRAs give the account owners the benefit of tax-free growth, as well as tax-free withdrawals.

Costs

Annuities are notorious for the large commission paid to the salesperson involved. Annuity commissions range anywhere from 1 percent to 8 percent of the total value depending on the contract, but you may pay as high as 10 percent or as low as 0 percent if you buy a commission-free annuity. That commission ultimately comes out of your returns.

Simple annuities are generally less expensive than complex ones. The specifics of each contract can vary, so make sure you understand the details regarding fees and commissions before committing your money.

In addition, most annuities come with a surrender period, during which you can face a penalty for withdrawing your money early, usually the first six to eight years of the account. These surrender charges tend to go down over time, though.

On the other hand, IRAs typically come with little to no cost and can be opened through most online brokers.

Risks

For annuities, key risks include inflation eating away at a fixed-dollar payment and variable annuities that may fall short due to market fluctuations.

For IRAs, the investing risk lies with you. If you don’t contribute enough during your working years or invest it wisely, you might not have enough to last during retirement.

Did you know? You can buy an annuity inside an IRA.

Bottom line

While both IRAs and annuities can offer investors the chance for tax-advantaged growth, they should really be thought of as two separate retirement options. An IRA is an account structure that you put assets into to shield them from taxes, while an annuity is an insurance contract designed to give you a steady income during retirement. Consider whether a financial advisor might be helpful when it comes to identifying your long-term goals and which product is better suited for your lifestyle.

— Bankrate’s Logan Jacoby contributed to an update of this article.