An annuity is one option for Individual Retirement Account (or IRA) money. Knowing how annuities work will help determine if using one for your IRA is a wise choice. It is important to understand the features and restrictions before selecting an IRA annuity. IRAs are tax-advantage retirement plans, and annuities also offer some tax benefits.
An annuity is a contract with an insurance company. A deferred annuity earns interest and grows until a withdrawal election is made. An immediate annuity provides fixed regular payments for a certain amount of time, or for the rest of the annuitant's life. Deferred annuities are popular saving vehicles because the interest rate they pay is often significantly above comparable bank CD rates, and they have a high level of safety. An annuity is one option for the investment of an IRA. In our context, the word "annuity" means a deferred annuity unless otherwise noted.
Annuity earnings grow tax-deferred until withdrawal and have tax penalties for withdrawal before age 59-1/2. Regular IRA deposits can be tax-deductible, and the earnings grow tax-deferred. The point is that putting away IRA money means putting tax-deferred savings into an already tax-advantaged vehicle. (You do not get double tax benefits.) The primary reason to have IRA money in an annuity is to earn a higher interest rate than banks are paying on CDs.
Annuity funds are not insured by any government agency. The safety of annuities is the financial strength of the issuing insurance company. Insurance companies must meet stringent financial requirements to stay in business, and many are very financially secure. The financial strength of the insurance company is the guarantee of any annuity contract. Understand the financial strength of the issuing insurance company before putting money into an annuity contract.
Variable annuities offer the choice of investing mutual funds in stocks, bonds and money market instruments. The value of the accounts will rise and fall with the underlying investments. Variable annuities offer a wrapper of tax-deferral and guaranteed death benefit around the funds. IRA earnings are already tax-deferred. The extra costs associated with variable annuities compared to mutual funds puts the annuities at a performance disadvantage. The Securities and Exchange Commission cautions against putting tax-qualified retirement funds into a variable annuity unless the the extra features of the annuity are the deciding factor.
Annuity interest rates are guaranteed for a fixed period of time--typically one to 10 years. After the guarantee period, rates are set by the insurance company. Annuities also have surrender fees that decrease over a period of years. The surrender period should be a close match to the rate guarantee period. If you will reach retirement age during the surrender penalty period, the contract should spell out the withdrawal options.
Tax law allows penalty-free withdrawals from IRAs after age 59-1/2. Annuities allow withdrawals, the same as other IRA options. You can take a full or partial lump sum, or set up regular payments from the annuity. A deferred annuity can also be converted to an immediate annuity, which will provide guaranteed payments for a fixed period of time or a guaranteed lifetime income.