Everyone knows that he should save for retirement. How much to save and how to save it, though, are two big questions with several different answers. Many invest in retirement plans through their employers, such as a 401(k). Two retirement vehicles that you can set up on your own are annuities and individual retirement accounts. Some employers offer IRAs as well. When it comes to an IRA or annuity and what’s right for you, the answer depends on your age, your goals and how much you’re planning to set aside, as well as other factors.
What Is an Annuity?
An annuity is a savings vehicle that you purchase from a financial services company. You make one or more payments to the insurance company and purchase an annuity. The annuity earns interest or dividends from investments depending on the type of annuity, and then the annuity is paid out to you in one or more payments.
What makes an annuity unique is the feature for which it’s named: annuitization. If you annuitize your annuity, the insurance company calculates a payment plan for you and guarantees that you will receive those payments for the rest of your life.
The advantage of an annuity is that you don’t need to pay taxes on the money your annuity earns, which is called tax deferral. Instead, you can leave the money in your annuity so it can be invested or earn more interest. You pay taxes on the growth when you receive payments from the annuity. For example, if you purchased an annuity for $50,000, and it grows to $75,000 by the time you start receiving payments, you will be taxed on the $25,000 growth as you take it out of the annuity. Another advantage is that there is no limit on how much money you can put into an annuity.
The disadvantage of an annuity is that the money isn’t liquid. If you need the money soon after you purchase the annuity, you will need to pay fees as well as taxes on the income you’ve earned. If you withdraw money before age 59 ½, you will also face a 10 percent tax penalty.
What Is an IRA?
An IRA is a retirement savings vehicle with tax advantages. The money in an IRA can be invested in a range of financial products, including mutual funds, stocks, bonds or certificates of deposit. The two types of IRAs with which most consumers are familiar are traditional IRAs and Roth IRAs.
With a traditional IRA, your contributions are tax deductible, which means you can claim the amount you put into a traditional IRA on your taxes and it lowers your taxable income. For example, if you earn $40,000 and put $3,000 into a traditional IRA, your taxable income will be $37,000. There is a limit to how much you can contribute to a traditional IRA each year, with an additional allowance if you’re age 50 or older. The 2018 limit is $5,500 or $6,500 if you’re age 50 or older. The IRS also limits how much you can deduct based on your income. If you file as single and you earn more than $73,000 in 2018, for example, you can’t deduct your contributions if you have a retirement plan where you work. You are also required to start taking payments from a traditional IRA beginning at age 70 ½.
A Roth IRA works a bit differently. Your contributions to a Roth IRA are not tax deductible, but the money grows tax free, and your withdrawals are also tax free. The contribution limits are typically the same as the limits for a traditional IRA, but there is no required minimum distribution starting at age 70 ½. There are limits on how much you can contribute based on your income and filing status. For 2018, single filers can make a full contribution if their modified adjusted gross income is less than $120,000 per year, a partial contribution if their income is $120,000 to $134,999 and no contributions if their income is $135,000 or more.
What’s the Difference Between an Annuity and an IRA?
The main difference between an annuity and an IRA is the limitations on how much you can contribute. IRAs limit how much you can contribute, but there is no upper limit on how much you can put into an annuity. Another difference is that you can have joint owners with an annuity, which isn’t possible with an IRA. You also are never required to take money out of an annuity, while you are required to take distributions if you have a traditional IRA.
When it comes to an annuity vs. an IRA, there is no right answer as to which is better. Ultimately, which vehicle is best for you depends on how much you’re planning to set aside, your income, your age and how you’re planning to invest the funds in each vehicle.
Melinda Hill Sineriz is a freelance writer with over a decade of experience. Her work has appeared on Pocket Sense and Sapling. She specializes in business, personal finance, and career writing. She has worked in insurance sales and financial planning, helping families to manage their money and prepare for the future. Learn more about her and her work at thatmelinda.com.