Annuity vs IRA: An Account, a Product, and How They Fit Together

People ask "annuity or IRA" the way they would ask "stocks or bonds," but the two words describe different layers. The IRA is the wrapper: a set of tax rules Congress attached to an account you open at a custodian. Inside that wrapper you can hold cash, certificates of deposit, mutual funds, exchange-traded funds, individual stocks and bonds, or an annuity contract. The annuity is one of the things that can go inside.

The confusion is understandable because an annuity bought with after-tax money also defers tax on its growth, so it looks like a retirement account. The IRS calls that a non-qualified annuity. It is the closest thing to an IRA you can buy without an IRA, and most of this guide compares those two: a traditional or Roth IRA holding ordinary investments, versus a non-qualified annuity.

Takeaway: Decide the account first (IRA, or not), then decide whether an annuity belongs inside it or alongside it.

An IRA has an annual contribution limit set by the IRS, indexed to inflation, with a larger catch-up amount for people 50 and older; the current figures are on the IRS site linked below. You need earned income to contribute, and the deduction for a traditional IRA phases out at higher incomes if you or your spouse are covered by a workplace plan. Roth IRA contributions phase out above income limits too, though a conversion from a traditional IRA has no income limit.

A non-qualified annuity has none of these rules. There is no IRS cap on the premium, no earned-income requirement, and no income phase-out. Insurers set their own minimums and maximums per contract. That is why a non-qualified annuity is often the next step for someone who has already put the maximum into an IRA and a workplace plan and still wants tax-deferred growth on additional savings.

The three columns below are the choices most people are actually weighing. A qualified annuity, meaning one held inside an IRA, follows the IRA column it sits in.

The clearest case is the saver who has maxed the IRA and the workplace plan and has more after-tax money that would otherwise sit in a taxable brokerage account or a bank CD paying interest that is taxed every year. A multi year guaranteed annuity defers that tax, and a deferred income annuity converts the money into a pension-style payment later. Neither requires earned income, so retirees can buy them with savings.

The second case is the person who wants guaranteed lifetime income from money outside retirement accounts. Annuitizing a non-qualified contract has a tax advantage of its own: each payment is split by the IRS exclusion ratio into taxable earnings and a tax-free return of premium, spreading the tax over the payout years instead of front-loading it.

The weaker cases are money you may need within the surrender period, and anyone under 59 and a half who cannot rule out withdrawing earnings early. The annuity's deferral is also less valuable in a low bracket, and assets that would get a stepped-up basis at death, such as appreciated stock in a taxable account, lose that benefit if they are sold to fund an annuity, because annuity gain is income to the heir.

• Good fit: after-tax savings beyond IRA and plan limits, a desire for guaranteed rates or lifetime income, buyers past 59 and a half.
• Poor fit: money needed within the surrender term, low-bracket savers with unused IRA room, appreciated assets that heirs would inherit with a step-up.

You can buy an annuity with IRA or rollover money, and many people do, to lock a guaranteed rate or to convert part of the account into lifetime income. Understand what you are and are not getting. The tax deferral of the annuity is redundant inside the IRA; the account already provides it. What you gain is the insurer's guarantee; what you pay is the contract's surrender schedule and any rider fees.

Required minimum distributions still apply to a traditional IRA annuity. A deferred contract reports a year-end value for the calculation, and most contracts let you withdraw the RMD free of surrender charges; once annuitized, the payments generally satisfy the RMD for that contract. A Roth IRA can hold an annuity too, with tax-free qualified payments and no lifetime RMDs.

Converting a traditional IRA annuity to a Roth is allowed. The taxable amount is the contract's fair market value, which under IRS rules can include the value of certain guaranteed riders, not just the cash surrender value, so get the insurer's conversion valuation before you decide.

Takeaway: Inside an IRA, buy the annuity for the guarantee. If all you want is deferral, the IRA already has it and ordinary investments cost less.

An IRA holding index funds or a brokered CD can cost close to nothing to maintain, and the holdings can be sold any business day; the only exit cost is the tax and, before 59 and a half, the penalty. A fixed annuity usually has no explicit annual fee but has a surrender charge for several years and a free withdrawal allowance, commonly 10% a year. Income riders on index and variable annuities charge an annual fee, and variable annuities add mortality, expense and fund charges.

Liquidity is therefore the honest tradeoff. The annuity gives up some access in exchange for a guarantee the IRA's investments cannot provide on their own. Sizing the annuity to the portion of savings you can leave alone for the term keeps the tradeoff comfortable.

Work through the questions in order; most people reach a clear answer by the third one.

• Have you filled this year's IRA (and workplace plan) contribution room? If not, and you have earned income, fund the IRA first; its tax treatment is better and its costs are lower.
• Do you want a guaranteed rate or guaranteed lifetime income for part of your money? If not, ordinary investments in the IRA or a taxable account are simpler and more liquid.
• Is the money you would commit free for the annuity's full surrender term, and are you past 59 and a half or certain you will not need the earnings sooner? If yes, a non-qualified annuity for after-tax money, or an annuity inside the IRA for retirement money, can do the job.
• Will heirs inherit this money? Compare an annuity's income-taxable gain with the step-up in basis a taxable brokerage account would give them.