Why an Annuity May Not Make Sense for Your IRA


Many investors are aware of the benefits of a tax-deferred individual retirement account (IRA). You may even have money invested in an IRA as part of your retirement savings plan. But as you approach retirement, you may begin to wonder if your Social Security payments and the investments within your IRA will provide sufficient cash flow to meet your longer-term financial needs. On the surface, including annuities in your IRA might seem an appealing way to receive steady, guaranteed income payouts. But the reality could be a different story.

It is natural for investors to want their retirement savings to grow, which is why many investors get nervous about losing their entire nest egg if the stock market falls. The fear of losing it all can drive investors to consider including annuities as part of their retirement strategy. After all, the lifetime income guarantees, perceived protection against the decline of principal, and tax treatment may all be features attractive to investors in retirement. However, the benefits of annuities are often misunderstood. As an example, the tax benefits provided for deferred annuities can be made irrelevant if the annuity is held in an IRA.

IRA Annuities

Annuities have a reputation for being complex. You have many choices, and deciding on an annuity contract can be daunting in itself. You must choose whether the annuity payments will start immediately (immediate annuities) or later on (deferred annuities). You can choose how often and for how long to receive payments. There are different annuity types—fixed, variable and indexed. As with an IRA or 401(k) plan, an annuity can grow tax-deferred, and you don’t pay taxes until you take withdrawals. Unlike IRAs and 401(k)s, annuities don’t have contribution limits.

However, annuities tend to be expensive relative to other choices. They come with high fees, often including potential surrender charges if you make an early withdrawal. Also, annuities are only as good as the insurance company who issues them. If the insurance company goes bankrupt, you may not receive the income you anticipated. For these reasons, it is almost always better to consider other investment options for your retirement account. If, after all your research, you decide to purchase an annuity contract, be wary of owning one in a tax-advantaged account such as an IRA. Retirement accounts and deferred annuities have similar tax treatment. That brings up the question of whether you really need to pay extra fees to defer taxes in an account that is already tax deferred.

Retirees are attracted to annuities for their guaranteed income payouts, enhanced death benefits, fixed-income yield payment (for some fixed annuities) and other unique investment features. Money invested in an IRA could represent the bulk of a retiree’s savings and is often invested in stocks, bonds or mutual funds. But you could also use your IRA money to purchase annuities or roll over an IRA into an annuity, tax-free. When you do this, the insurance company can set up an IRA annuity to which you can transfer your retirement funds. This often leads investors to believe they can take advantage of the benefits they believe annuities have. In reality, it may be inefficient to roll over or dip into your IRA assets to purchase annuities.

IRS Tax Treatment of Annuities

First of all, an annuity is an insurance contract between the purchaser and an insurance company. While annuities can include underlying investments, by itself it isn’t an investment. The main difference between an insurance product and an investment is that an insurance product’s principal can terminate at the end of the contract, unless you pay for extended benefits. An investment’s principal value can grow beyond your life expectancy.

Annuity contracts offer tax-deferred status to money in a taxable account. The funds in an annuity typically aren’t subject to capital gains taxes. But any funds you withdraw from an annuity are generally subject to ordinary income taxes.

This is one reason FINRA recommends most investors take advantage of other available tax-advantaged accounts before considering annuities.* Holding a deferred annuity within a traditional IRA may provide no additional tax advantage.*

If you purchase an immediate annuity with after-tax money in a Roth IRA, your distributions will be tax-free. If you purchase a deferred annuity, the same tax treatment applies, but you would be adding a tax-deferred product into a tax-sheltered IRA. In most cases, the Roth IRA’s tax treatment will supersede that of the annuity, rendering the annuity’s potential tax advantage moot.

Annuities Held in a Taxable Account

If you purchase annuity products in a taxable account such as an IRA, it could add a layer of complexity when it comes to figuring out required minimum distributions (RMDs). These vary depending on the annuity type in your IRA. Distributions may be more confusing with some annuity types than with others. For example, if you hold an immediate annuity and receive a lifetime income stream, the payments cover the RMD for the portion of the IRA money invested in the annuity. If you have a qualified longevity annuity contract (QLAC), your RMDs may be based only on the non-annuity part. If you hold a variable deferred annuity, RMDs are related to whether the annuity has been annuitized. These variations can get complicated, and it is best to seek the advice of a qualified financial adviser.    

You may be up against the following disadvantages:

  • In addition to the various costs you pay, such as management fees and rider fees, which add up to high annual fees, you may face additional penalties if you take withdrawals before age 59½.
  • Your early withdrawal tax penalty may be compounded by additional surrender fees, which may be quite steep.

There are Other Investment Options

IRA annuities may not be ideal for your longer-term objectives. You have many options when it comes to generating income in retirement. For more information about annuities and other tax-advantaged investment options for retirement income, read Annuities Insights today.

*Source: Financial Industry Regulatory Authority, Inc., Variable Annuities: Beyond the Hard Sell (FINRA, 8/31/2009).

**Source: 2011 Insured Retirement Institute Factbook. Exact quote: “At the end of 2010, variable annuity assets invested in qualified retirement plans totaled $1.04 trillion, or 68.9% of total variable annuity assets.”

The contents of this document should not be construed as tax advice. Please contact your tax professional.

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