Why Is an Annuity Put Inside an IRA?

For many investors, the security of an annuity makes it a good choice for their IRA. If you choose a fixed annuity, you are guaranteed a set payment every month or year for the life of the annuity. This can make an annuity a particularly useful tool to meet your IRA's minimum distribution requirement or to pay fixed bills that you plan to have in retirement, like a mortgage.

Annuities are also frequently safe investments. Many of them are backed by insurance companies that have billions of dollars of holdings and financial strength. While variable annuity returns fluctuate, they always have a floor below which your return cannot go, and, as long as your annuity company remains solvent, you'll get those payments.

When you combine an annuity with a Roth IRA, the investment can become more attractive. While you pay taxes on the money that you put into a Roth IRA, you withdraw from your Roth without paying taxes. This means that if you buy an annuity that pays $1,000 per month every month, you'll get exactly $1,000 per month out of your Roth IRA, since taxes won't come out of it. You can even use the proceeds of sales of assets in your Roth to buy an immediate annuity inside the account. This strategy can let you buy growing investments over time then, when you're ready to start withdrawing, lock in a set return.

If you buy an annuity that is designed to pay until you die, your return from it is directly proportional to how long you live. If you die before your insurance company plans, it may get to keep any of the extra money that you pay it. On the other hand, if you buy a guaranteed lifetime annuity and live to 100 or 110, well beyond what your insurance company expects, you'll keep getting paid, increasing your overall return. While it's hard to predict how long you will live, if you have positive indicators like very good health and family history of longevity, an annuity might turn out to be a good investment.

Even if a financial advisor would recommend an annuity, it's less likely that she'd recommend you hold it in an IRA for one key reason. Annuities work similarly to an IRA in that the money in the annuity grows without you having to pay yearly taxes on the growth. Other than the initial write-off for depositing the annuity, you're wasting your IRA's ability to grow money tax-free by putting an annuity in it. You would gain more tax-deferral benefits by holding the annuity outside your IRA and putting high-yield bonds or a dividend-paying mutual fund in the IRA where the cash from those investments would accrue tax-free.