The federal government wants you to save and invest for your retirement. It offers a powerful inducement to do so, in the form of tax breaks on certain retirement accounts. Two popular tax-advantaged retirement programs are individual retirement accounts and annuities. You can choose to use one or both, and even place an annuity within an IRA. Annuities also can offer additional benefits, including death benefits and long-term-care insurance.
You contribute money to an IRA and invest the contributions in various investments, including certificates of deposit, stocks, bonds and mutual funds.
An annuity is a life insurance product that you purchase to create a stream of income that you begin collecting either right away or at a future time. You can buy an immediate annuity, in which you make a lump sum payment and begin receiving income, or a deferred annuity, where you build up the cash value of the policy before starting withdrawals. Different types of annuities offer a fixed return or a variable one based upon the performance of the investments held within the annuity. Generally, annuities charge higher fees than do IRAs.
You can contribute up to $5,550 of your income into your IRA each year -- or $6,500 if you've reached age 50 -- until you reach age 70 1/2. In a traditional IRA, the contributions are tax deductible, but withdrawals are taxed as ordinary income. Contributions to a Roth IRA are not deductible, but withdrawals are tax-free as long as you follow the rules. Contributions to an annuity are not limited to a certain amount, nor are they tax-deductible, unless the annuity is "qualified" -- held in an IRA or a workplace retirement plan.
Your IRA and annuity investments grow tax-free or tax-deferred until the money is withdrawn -- that's one of the important tax breaks. Generally, all these accounts charge a 10 percent penalty on withdrawals before age 59 1/2, although several exceptions exist for IRA owners. Traditional-IRA and qualified annuity owners begin taking withdrawals once reaching age 70 1/2, and these annual required minimum distributions are based on the owner's life expectancy. Roth IRA's and non-qualified annuities do not compel you to withdraw money during your lifetime.
You must pay taxes on withdrawals from traditional IRAs and annuities, but not from a Roth IRA. Normally, all distributions from qualified annuities and traditional-IRAs are included in your annual taxable income. Distributions from a non-qualified annuity are taxed to the extent they exceed the amount of non-deductible contributions you make. Generally, you prorate your withdrawals between contributions -- distributed contributions from a non-qualified annuity are not taxable -- and investment returns to determine your tax bill. Capital gains taxation, which gives you a tax-break on investments held for more than one year, is not available on distributions from IRAs and annuities.