Differences between annuities and IRAs
As tax season comes to an end, many people are trying to decide the best way to plan for retirement. The question I have been asked this past week is to explain the difference between an IRA and an annuity.
The answer is simple: tax treatment. IRS rules regulate both IRAs and annuities.
Individual Retirement Accounts (IRAs) consist of two types, traditional and Roth. Annuities consist of deferred and immediate. While both are designed to encourage saving for retirement, the way they are taxed is different.
A traditional IRA and a Roth IRA require you to have earned income. With a traditional IRA, contributions can reduce your income for tax purposes. So part of the money contributed would have gone to the government if you had not opened a traditional IRA. The money in the IRA can be placed in some type of investment vehicle and per tax code cannot be touched without penalty until you are 591/2 years old. When you start withdrawing money, you will be taxed on the growth within the investment. Presently the tax code also requires you to start taking part of the money by age 72. The requirement is referred to as (RMD) – required minimum distribution. RMDs are based on a formula using life expectation. Using this formula, the amount of the RMD will change each year. Understand after age 59 1/2, you can take any amount out of your traditional IRA, but once you reach age 72, RMDs come into play.
A Roth (IRA), on the other hand, is funded with after-tax dollars. Roth IRA rules dictate that as long as you’ve owned your account for five years and you are 59 1/2 or older, you can withdraw your money when you want and you won’t owe any federal taxes – no RMDs and no tax on the growth.
An annuity does not require earned income. Annuities are only sold by insurance companies. Money placed into an annuity grows tax-deferred. You pay tax on the growth only when you receive it. When you purchase a deferred annuity, your money accumulates tax-deferred. The deferral ends when you take the money. Deferred annuities are sold for periods of time – three years, five years, 10 years or lifetime. Understand that deferred annuities have surrender charges: If you take your money before the contractual agreements within the annuities, you can be penalized.
When you purchase an immediate annuity, you give the insurance company money with an agreement that it will provide you guaranteed monthly income for as long as you live. The monthly income usually begins within 30 days of your giving the insurance company money. Understand that the money received is part growth and part return of principle, with principle being the money you gave the insurance company to open the account. You will be taxed only on the growth part of your monthly income.
I mentioned earlier that with an IRA there are investment vehicles in which the money is placed. An annuity can be one of the investment choices you make. Annuities are sold with fixed interest rates and variable rates of return. An annuity with a variable rate of return invests in securities. A fixed-rate annuity is similar to a certificate of deposit, with the insurance company guaranteeing the rate of return for specific periods of time. You may also choose an annuity to fund your IRA because you want the benefits of getting guaranteed monthly income some time in the future.
If you participate in a retirement plan you may not be able to open an IRA based on your income. Check with a tax adviser to make sure you are eligible for an IRA. If not, an annuity could help supplement your retirement income.
Bob Hollick is a State Farm Insurance agent based in Washington. His column appears every other Friday in the Observer-Reporter.