Many investors ask what is an annuity and whether an annuity policy is better than an IRA. This makes knowledge about annuities critical in making a financial decision between the two investment options.
In this article:
- What Is an Annuity Plan?
- What Are the Available Contribution and Payout Options for Annuity Policies?
- What Are the Stages in an Annuity?
- What Are the Different Kinds of Annuities?
- What Are the Similarities Between an IRA Over an Annuity?
- How About the Difference Between an Annuity Versus an IRA?
- Why Do Investors Pick an Annuity Over an IRA?
- Who Benefits From an Annuity?
- When Does an IRA and an Annuity Work Best?
“What Is an Annuity Plan?” and Other Questions for the Interested IRA Investor
What Is an Annuity Plan?
An annuity plan is a financial product that enables policyholders to enjoy tax-deferred investment growth. The policy functions as a source of fixed income, usually for people who have already retired.
Investors can get an annuity plan from financial institutions, usually insurance companies and banks. These entities accept the contributions and manage them for growth.
Once the policy reaches a specific time or contribution amount, it will up for annuitization. The financial institution will annuitize the policy.
Annuitization Definition: The process of converting an annuity from being a savings and investment account into an income-generating asset. Annuitization automatically switches on upon reaching either a stipulated contribution level or with the policy owner reaching an agreed-upon age.
What Are the Available Contribution and Payout Options for Annuity Policies?
Contribution methods have two main classifications:
- Lump Sum Contribution — Some IRA owners can start with a lump sum contribution. One example is when someone gets a huge windfall, like an inheritance. They can choose this method to take advantage of the lack of contribution limits.
- Installment Plan Contribution — The most common contribution method is with an installment plan. Here, the client contributes annually, quarterly, or monthly until reaching the annuitization phase.
On the other hand, withdrawal methods depend on what’s in the contract of an annuity plan.
The contract stipulates the rate of return after the stipulated number of years, which creates a payment schedule. Annuity payout options usually lean towards a monthly income stream. However, annual and quarterly payments also exist.
What Are the Stages in an Annuity?
Annuities have two phases, which are the accumulation phase and the annuitization phase.
- Accumulation Phase — In the accumulation period, the investor funds the account. The contributions will also continue to grow during the accumulation phase until annuitization kicks in.
- Annuitization Phase — During the annuitization phase, the investor stops contributing and the policy locks in the current total investment value. The policy then starts giving the investor scheduled payments according to the stipulations in the contract.
What Are the Different Kinds of Annuities?
Annuities come in two main classifications.
- The first category is based on the growth rate and withdrawal system for an annuity plan.
- The other classification is based on the schedule of payments or withdrawals.
Classification 1: Based on Growth Rate and Withdrawal System
For the first classification, there are four main types according to growth and withdrawal rates. There is a fixed, variable, indexed, and a lifetime annuity plan.
- Fixed — An investor can choose fixed annuities, which offer a guaranteed yearly growth rate.
- Variable — The growth rate of variable annuities follow a particular investment vehicle like an index, mutual fund, or a group of assets.
- Indexed — An indexed annuity provides the investor with the chance to grow his or her money through a guaranteed rate or an index agreed upon, whichever is higher. For example, if the indexed annuity follows the S&P500 which grew by 5% while the guaranteed rate is 6%, the annuity grows by 6%.
- Lifetime Annuity Plan — Another type, which is the lifetime annuity plan, is rarer nowadays due to the risk of policy owners possibly outliving both the capital and the profits in an annuity. Most lifetime annuities have a fixed rate, with some policies not even having a stated amount—only a provision that the annuity will provide the agreed income until the policyholder’s death.
Classification 2: Based on the Schedule of Payments or Withdrawals
Another way to classify annuities is based on when the policyholder will receive money from the plan. This can either be an immediate annuity or a deferred annuity.
- Immediate — An immediate annuity pays immediately after receipt of contributions.
- Deferred — A deferred annuity waits until the policyholder reaches a specified age or contribution amount before he or she can receive payments.
What Are the Similarities Between an IRA Over an Annuity?
Both an IRA and annuity plan can grow free of tax when the capital stays in the account. This tax-saving character provides a better investment environment as the government does not tax growth.
Annuities and IRAs have two important similarities in their funding and withdrawal taxation models.
- Traditional IRAs and Annuities — Traditional IRAs and annuities funded by money that hasn’t been taxed yet will be subject to taxable income levels upon withdrawal. This means that the entire withdrawal will have corresponding taxes.
- Roth IRAs and Annuities — In cases where the money has already been previously taxed, as in the case of a Roth IRA or an annuity, its post-tax contributions will be free of tax upon withdrawal. However, the investment will still be subject to taxes based on the income levels upon withdrawal.
How About the Difference Between an Annuity Versus an IRA?
How Investors Usually Use Each Plan
Investors can use an annuity plan as an income stream upon reaching retirement. On the other hand, an IRA is used more like a savings account where investors can withdraw when needed and enjoy tax benefits.
Another big difference between the two investment vehicle lies on contribution limits.
Non-qualified annuities don’t have contribution limits, unlike Roth and Traditional IRAs, which do. These limits generally increase as time goes on. As of 2019, the limits have increased to $6,000 from the previous $5,500, with the catch-up benefit for investors 50 years old and above remaining at $1,000 per year.
Finally, another difference is that annuities usually have higher expenses compared to an IRA.
Why Do Investors Pick an Annuity Over an IRA?
For investors who can contribute above the limits stipulated by the law, an annuity can function as an extra account. This second account can also provide additional tax breaks and tax-free growth, which can make annuities a great complementary investment to IRAs.
A lot of employers also offer annuity plans for their employees. These employer plans typically have better terms than individual annuity policies.
Another reason lies with the guaranteed rates, as IRAs don’t offer fixed rates. Annuity providers can offer a fixed annuity, which can add stability for a retiree, and the earlier annuity policies usually have great guaranteed rates.
An annuity can also have additional riders like most insurance policies. These riders, like tied-in medical insurance, can greatly increase the attractiveness of an annuity.
Lastly, some successors of an estate inherit annuities and keep them, rather than withdraw the money or rollover to an IRA. Keeping the money in the annuity can stop the 10% penalty found for withdrawals before investors reach 59 and ½ years old.
Who Benefits From an Annuity?
Some investors prefer annuities because it allows their capital to grow tax free. Investors who want investments in a combination of guaranteed rates and variable growth can ask for a hybrid of fixed and variable annuities. This can provide great diversification for the retirement journey.
People who get a large windfall, like a big inheritance or a retirement package from a company, can also benefit from buying a single-premium annuity. This method allows a bigger capital to grow tax-free since they won’t be subjected to the annual contribution limits of an IRA.
Annuities benefit retirees by providing a guaranteed income until either exhausting the money in the annuity or until the policyholder’s death.
Successors of an estate can also benefit, as most annuities also have a death benefit rider where the beneficiaries receive the remaining money in the account.
When Does an IRA and an Annuity Work Best?
Investors who can invest only up to the contribution limits may find an IRA cheaper as management and custodian fees are lower compared to annuities. The more enterprising and enthusiastic investor may also prefer the IRA since they can have more control over their investments.
IRAs, especially self-directed ones, can accept almost everything as an investment, except for a few exceptions set by the IRS.
On the other hand, annuities function like a hybrid savings account and insurance policy. Investors who can contribute above the limits set by the law can enjoy tax-free growth without the restrictions of contribution limits.
Another benefit to annuities is that custodians manage them, which means the investor will have one less thing to worry about.
Knowledge of annuities, together with good budgeting techniques, can make the financial journey to retirement easier. Investors may consider complementing their IRA with an annuity to better prepare for what lies ahead in their golden years.
Do you have an annuity? What are your thoughts about having both an IRA and an annuity? Let us discuss in the comments section below.