Pros and Cons of Converting an IRA to an Annuity

Retirement planning involves making strategic decisions about how to manage your savings for long-term financial security. One option that some retirees consider is converting an IRA to an annuity. This financial move transforms your retirement account from a self-managed investment vehicle into a product that provides guaranteed income streams. While IRAs offer tax advantages and investment flexibility, annuities can provide predictable payments for a specified period or even for life. This conversion isn’t right for everyone, as it involves weighing factors like your risk tolerance, income needs and long-term financial goals.

A financial advisor can help you build a retirement plan for the future.

Pro: Annuities Generate Reliable Income

If you’re worried about running out of money in retirement, an annuity can help allay your fears. In exchange for your premium (or money in your IRA), the insurance company would guarantee steady payments for life (or a set number of years). You can start these payments right away or within a year if you get an immediate annuity, or have your money grow before you start payments if you get a deferred annuity.

If a steady stream of checks sounds good to you, experts often recommend getting an annuity to cover your fixed monthly expenses. That way, you may not need to hand over all of your nest egg to the insurance company.

Certainly, the regular cash flow from an annuity can make it easier to manage your finances in retirement. You’ll get a set amount every month (or quarter or year), so you don’t have to worry about drawing down your nest egg when the stock market is volatile. There’s also the promise that you will receive payments as long as you live, no matter how long that is. You may prefer this protection if you’re a conservative investor.

Con: You May Not Get to Use All Your Money

SmartAsset: Converting an IRA to an Annuity

One of the main drawbacks of converting an IRA to an annuity is that once you start receiving payments, you can’t pull the money back out. Even if you become very sick and know that you won’t live as long as you expected, you can’t cancel the contract. Should you die prematurely, your nest egg will stay with the insurance company – and not go to your heirs. That’s the chance the insurance company took when it sold you the annuity. (You, of course, took the opposite chance that you would receive more in payments than you put in.)

Of course, you can pay extra for riders that provide for your spouse or beneficiaries. For example, you could get an annuity with survivor benefits, where payments will continue for a set period or the survivor can choose to receive a lump sum. Or you could get a joint annuity that covers both lives of a married couple, or a joint annuity with survivor benefits. These riders, though, are expensive and will likely lower the amount you receive as your regular payments.

That said, if you buy a deferred annuity and haven’t annuitized yet, you can get your cash back. But you’ll pay steep fees to the insurance company, plus a 10% penalty to the IRS if you aren’t 59.5 years old yet. If you die before you annuitize, most annuities will return your premium minus any withdrawals and fees to your beneficiary.

Pro: Annuities Don’t Require You to Be Hands-On

One of the nice things about converting an IRA to an annuity is that you don’t have to do anything other than collect a check afterwards. You don’t have to worry about rebalancing your portfolio or tracking returns because the payments you’re receiving are exact. That can be appealing to investors who favor a passive approach.

When you purchase an annuity, financial professionals handle the investment decisions behind the scenes. Insurance companies employ investment experts who manage the underlying assets that fund your annuity payments. This professional management eliminates the need for you to research investments, rebalance portfolios, or make timing decisions about buying and selling assets.

Con: Passivity Comes at a Cost

The privilege of not spending a lot of time managing annuity investments comes with a price tag. Brokers or insurance agents will charge a commission. If it’s indirect, it’ll be part of the calculation of your payouts. If it’s direct, it’s often calculated as a percentage of assets involved. So if you’re converting $250,000 in assets and there’s a 10% fee, that’s $25,000 that goes straight into the broker’s pocket.

Annuities often come with annual fees as well. These fees are for managing the annuity and are similar to the administrative fees you’d pay for a mutual fund in an IRA. The difference, however, is that you could end up paying more fees through an annuity.

Pro: Protection Against Market Downturns

One significant advantage of converting an IRA to an annuity is protection from market fluctuations. Unlike traditional IRAs that remain invested in the market, annuities can offer principal protection and insulate your retirement income from economic downturns. This security becomes increasingly valuable as you age and have less time to recover from significant market losses.

Fixed annuities deliver predictable returns regardless of market conditions. These products guarantee a specific interest rate for a set period, creating a reliable income stream that remains unchanged even during severe market corrections. This stability makes fixed annuities particularly attractive for those approaching retirement who can’t afford to weather significant investment losses.

Con: Potential Tax Consequences

Converting an IRA to an annuity comes with important tax considerations. While the conversion itself isn’t typically a taxable event, how you receive distributions from the annuity will impact your tax situation. Understanding the tax implications before making this decision is crucial, as annuity distributions are generally taxed as ordinary income.

How annuity withdrawals are taxed depends largely on whether you purchased the annuity with pre-tax or after-tax dollars. For qualified annuities purchased with pre-tax money (like those in traditional IRAs or 401(k)s), withdrawals are generally taxed as ordinary income. With non-qualified annuities purchased with after-tax dollars, only the earnings portion of withdrawals is taxable, following what’s known as the “last in, first out” principle.

Bottom Line

Converting an IRA to an annuity presents both advantages and potential drawbacks that require careful consideration. Before converting an IRA to an annuity, consider consulting with a financial advisor who can evaluate your specific retirement goals, income needs, and risk tolerance. The decision should align with your overall financial plan rather than being made in isolation. By weighing these pros and cons carefully, you can determine whether this retirement strategy makes sense for your unique situation.

Tips for Retirement Planning

Planning for retirement can be a complex venture, but a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
It’s never too early to start planning for retirement. A retirement calculator can help you figure out how much you’ll need to retire comfortably. Building a sizable nest egg may enable you to delay Social Security benefits. This will allow you to maximize your monthly payments once you are ready to collect.