What’s an Individual Retirement Annuity? How they work, contribution limits and payouts

As you plan for retirement, building a secure nest egg becomes a top priority. Individual retirement annuities and individual retirement accounts (IRAs) are two similar-sounding options, but they function in very distinct ways.

This article explains how individual retirement annuities work, their advantages and disadvantages and how they compare to IRAs.

Here’s what you need to know.

What is an individual retirement annuity?

An individual retirement annuity is a financial contract issued by an insurance company. This type of annuity functions similarly to a traditional IRA in that it offers tax benefits while allowing contributions to grow for retirement.

However, unlike traditional IRAs where you invest in a variety of assets like stocks, bonds and mutual funds, an individual retirement annuity limits your investment options to fixed or variable annuities.

Fixed annuities offer guaranteed growth and payouts based on a predetermined interest rate set by the insurance company. Variable annuities, on the other hand, tie your returns to the performance of underlying funds, potentially offering higher returns but also carrying greater risk.

Think of an individual retirement annuity as a hybrid between an IRA and a life insurance product. It defers taxes like an IRA while offering the guaranteed income stream annuities are known for.

How individual retirement annuities work

Understanding how individual retirement annuities function requires examining two key aspects: Contributions and payouts.

Contribution limits

Individual retirement annuities adhere to the same contribution limits set by the IRS, just like traditional and Roth IRAs. In 2024, the contribution limit for IRAs, including individual retirement annuities, is $7,000 per year, with an additional $1,000 catch-up contribution allowed for people age 50 or older.

You make regular premium payments to the insurance company managing your individual retirement annuity. These contributions are similar to how you might contribute to a traditional IRA. The insurance company then invests these contributions according to the type of annuity you choose (fixed or variable).

Payouts

Unlike a traditional IRA where you 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 different payout options. You can opt for a lifetime income stream, ensuring you receive payments for as long as you live. Alternatively, you can choose a fixed payout period, guaranteeing income for a specific number of years.

Some annuities offer a death benefit, providing a payout to your beneficiaries. According to the IRS, either you or your beneficiaries who survive you are the only ones who can receive benefits or payments. In other words, you can’t sell your future annuity payments to a third-party company, like you can with some other types of annuities.

IRA vs. individual retirement annuity: Key differences to know

While both individual retirement accounts and individual retirement annuities fall under the IRA umbrella, they are distinctly different.

• Investment choices: Traditional and Roth IRAs offer an array of investment options. In contrast, individual retirement annuities limit your choices to just fixed or variable annuities.
• Control: With an IRA, you have complete control over your investments. You can choose your asset allocation, adjust your portfolio as needed and withdraw funds if necessary, albeit with some limitations. Individual retirement annuities offer less control, especially after converting your contributions into an income stream.
• Income stream: Traditional and Roth IRAs don’t guarantee a steady retirement paycheck. You access your funds directly, and the income you receive depends on how you manage your withdrawals. The onus is on you to make that money last your entire retirement. Individual retirement annuities, on the other hand, offer a reliable income stream, similar to a paycheck or pension, that’s guaranteed by the life insurance company issuing the annuity contract.

Benefits of individual retirement annuities

Individual retirement annuities come with several advantages that can be appealing for retirement planning.

• Guaranteed income: The biggest advantage is the guaranteed income stream. Unlike traditional IRAs, which you’re responsible for managing, individual retirement annuities shift the responsibility of management and withdrawals from you to the insurance company.
• Tax advantages: Similar to traditional and Roth IRAs, individual retirement annuities come in two types: qualified and non-qualified. Qualified annuities let you deduct what you contribute from your taxable income in the year you make the contribution. However, withdrawals are taxed as ordinary income in retirement. Meanwhile, non-qualified annuities provide no upfront tax break on contributions but you can withdraw your money tax-free in retirement.
• Death benefit: Some individual retirement annuities offer a death benefit, providing a payout to your beneficiaries — typically a spouse — if you pass away.

Drawbacks of individual retirement annuities

While individual retirement annuities offer some benefits, they’re not for everyone, and it’s important to understand their drawbacks.

• Limited investment options: Compared to the flexibility of IRAs, individual retirement annuities limit you to fixed or variable annuities. If you prefer a more hands-on approach to managing your retirement portfolio or have a higher risk tolerance, an individual retirement annuity likely isn’t a good fit.
• Fees: Individual retirement annuities typically come with higher fees compared to traditional IRAs. These fees can include mortality and expense fees, surrender charges (penalties for early withdrawal) and administrative fees. These fees can add up quickly and eat into your returns over time.
• Less liquidity: Once you convert your contributions into an income stream, accessing your funds can be next to impossible. This may not provide the level of access you need in an emergency.
• Tax implications: While contributions to traditional individual retirement annuities may be tax deferred, the tax bill eventually comes due and withdrawals and distributions in retirement are taxed as ordinary income. Traditional retirement annuities are also subject to required minimum distributions starting at age 73.
• Sensitive to inflation: Fixed annuities may not keep pace with inflation over time. While some offer cost-of-living adjustments, they might not fully compensate for rising prices, potentially eroding your purchasing power over time.

Who should consider individual retirement annuities?

Individual retirement annuities might be a good fit for some people, but not everyone.

If you prioritize security and guaranteed income over potentially higher returns, these products can be a good fit. Likewise, if you’re concerned about outliving your retirement savings, individual retirement annuities with lifetime income options can offer a safety net.

How to buy an individual retirement annuity

If you’re considering buying an annuity, make sure to do your research first. Educate yourself on the two types of individual retirement annuities (fixed vs. variable) and understand the fees involved.

Don’t settle for the first annuity you come across. Compare contracts and quotes from multiple insurers, focusing on fees, payout options and surrender charges.

Speaking with a qualified financial advisor, while not required, is a smart move to make before moving forward. A financial advisor can assess your specific needs and risk tolerance and help you determine if an individual retirement annuity is right for you.

Bottom line

Individual retirement annuities offer a unique blend of tax benefits and guaranteed income in retirement. However, they come with just two investment options, higher fees and less liquidity than a traditional IRA. Carefully consider your specific circumstances and retirement goals before investing.