How an Individual Retirement Annuity Works

An individual retirement annuity can provide guaranteed lifetime income, making it a potentially useful tool in retirement planning. It also comes with tax perks, similar to other retirement planning tools such as an Individual Retirement Account (IRA). However, individual retirement annuities differ from IRAs in key ways, including investing costs and flexibility in selecting investments.

Before buying an individual retirement annuity, consult a financial advisor to see if it fits your goals.

Defining an Individual Retirement Annuity

An individual retirement annuity is an annuity held within a tax-advantaged account similar to an IRA. With an individual retirement annuity, however, you make premium payments to the insurance company rather than contributing deferred salary to an IRA. Later when you retire, rather than taking funds from your IRA to get money to pay expenses, you get regular guaranteed payouts from the insurance company.

Another important difference versus a traditional IRA is that an individual retirement annuity can only hold annuity contracts rather than general investments. You purchase an annuity contract from an insurance company.

To buy the annuity, you pay either a lump sum upfront or make periodic premium payments to the insurance company. In return, the insurer provides reliable income payments, either immediately or starting later. The money in your annuity grows tax-deferred until you take withdrawals.

There are two primary types of annuities. Immediate annuities provide income right after purchase when you give the insurer a lump sum. Deferred annuities begin making payments years later, allowing time for your account to grow through periodic contributions.

Using Annuities in Retirement Planning

The main reason to use an annuity is to guarantee lifetime income that lasts your entire retirement. Having guaranteed lifetime income helps hedge against longevity risk or the chance that you will outlive your money.

Typically, monthly payments from the annuity get used to supplement regular income from other sources such as Social Security or pension benefits. Annuities provide peace of mind because they can be used to minimize the risk of outliving your income stream.

Other potential benefits include:

Death benefits to beneficiaries if you pass away early

Spousal benefits so a surviving spouse keeps getting income

Tax-deferred growth during the savings phase

Customizable features for an added cost

How Individual Retirement Annuities and IRAs Differ

SmartAsset: How an Individual Retirement Annuity Works

While both individual retirement annuities and IRAs help you save for retirement with tax advantages, they operate in different ways. An individual retirement annuity is an insurance product that provides guaranteed income during retirement, while an IRA is an investment account that can hold various assets like stocks, bonds and mutual funds. The main difference lies in how they grow and distribute your savings, annuities focus on predictable income, whereas IRAs emphasize investment flexibility and potential growth.

With an individual retirement annuity, your funds are managed by an insurance company that promises to pay a fixed or variable stream of income in the future. In contrast, an IRA is typically opened with a brokerage or financial institution, where you make your own investment choices. The annuity offers built-in income protection, while the IRA’s performance depends on the investments you select and how the market performs.

An individual retirement annuity provides a level of security that a standard IRA cannot, the assurance of guaranteed income for life or a set period. IRAs, however, allow for greater growth potential since they are directly tied to market performance. That means IRAs carry more risk but can also deliver higher long-term returns, while annuities trade that growth opportunity for income stability and peace of mind.

Both individual retirement annuities and IRAs share similar tax advantages, such as tax-deferred growth and potential deductions for contributions. However, the IRS imposes specific annual contribution limits that apply to both types of accounts combined. Withdrawals from either are taxed as ordinary income, and taking money out before age 59½ generally triggers a 10% penalty, though annuities may also carry additional surrender charges depending on the contract.

Pros and Cons of an Individual Retirement Annuity

BIndividual retirement annuities can play a valuable role in a retirement strategy, offering guaranteed income and tax-deferred growth. However, like any financial product, they come with trade-offs. Understanding the advantages and drawbacks can help you decide whether an individual retirement annuity aligns with your goals, risk tolerance and retirement timeline.

Pros of Individual Retirement Annuities

Protection From Market Volatility: Fixed individual retirement annuities, in particular, shield your principal and future income from market downturns. Even when markets decline, your payments remain consistent, making them a strong choice for conservative investors who prioritize security over growth.

Guaranteed Lifetime Income: One of the biggest advantages of an individual retirement annuity is the promise of steady income that can last for life. This guarantee helps eliminate the risk of outliving your savings, providing peace of mind and financial stability in retirement. For many retirees, that predictability outweighs the potential for higher market-based returns.

Tax-Deferred Growth: Like traditional retirement accounts, individual retirement annuities allow your investment to grow tax-deferred. You won’t owe taxes until you begin taking withdrawals, which allows your money to compound more efficiently over time. This feature makes annuities particularly attractive for long-term savers looking to maximize future income.

Cons of Individual Retirement Annuities

Limited Liquidity: One major drawback of annuities is their lack of flexibility. Once you purchase an annuity, accessing your funds early can trigger surrender charges, penalties and taxes. This makes them less suitable for investors who may need short-term access to their money.
Fees and Costs: Individual retirement annuities often come with higher fees than other retirement accounts. These can include administrative costs, mortality and expense charges and optional rider fees for added benefits. Over time, these expenses can eat into your overall returns.
Less Growth Potential: Compared to an IRA or other investment accounts, annuities generally offer lower returns because they trade growth potential for income security. While variable annuities provide some market exposure, they still may underperform traditional investments after accounting for fees.

An individual retirement annuity can be a powerful retirement planning tool for those seeking guaranteed income and peace of mind. However, it’s not ideal for everyone, particularly investors who want liquidity or higher long-term growth. A financial advisor can help you weigh these pros and cons and determine how an individual retirement annuity fits within your broader retirement strategy.

An Individual Retirement Annuity Example

A 65-year-old recently retired man with $300,000 in his IRA and $2,500 per month from Social Security wants more guaranteed income without giving up all prospects for additional growth. He uses $150,000 of the funds in his IRA to purchase an immediate annuity that pays 6% or $9,000 annually. This provides him with an additional $750 per month of lifetime income.

The remaining $150,000 in his IRA stays invested in mutual funds for growth. By 70, Ken can start tapping these funds for discretionary spending. Meanwhile, his Social Security benefits, which are indexed to inflation, plus the annuity income will likely cover his basic costs no matter how long he lives.

How to Buy an Individual Retirement Annuity

If an individual retirement annuity is right for you, here are five common tips to buy one:

Consider your target for guaranteed retirement income needs

Research and select an annuity provider with strong financial ratings

Choose between immediate or deferred annuities

Review all fees, terms and limitations before signing the contract

Fund the annuity from existing IRA savings or rollover accounts

Assessing the costs, benefits and features of the many annuity types can be complex. Work with a financial advisor for guidance on selecting an annuity.

Bottom Line

An individual retirement annuity can provide the security of guaranteed lifetime income and the benefit of tax-deferred growth, making it an attractive option for retirees who value stability and predictable cash flow. However, its limited liquidity, higher fees and lower growth potential mean it’s not the right fit for everyone. Balancing an annuity with other retirement accounts, like IRAs or 401(k)s, can offer both steady income and long-term growth.

Tips for Retirement Planning

Consider discussing annuities with a financial advisor to see if one fits your retirement strategy. 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.
You can’t plan wisely for retirement unless you have a fix on your Social Security benefits. Use SmartAsset’s Social Security Calculator to get answers.