When it comes to long-term retirement planning, many investors will consider opening an individual retirement arrangement (IRA) account or purchasing an annuity contract, such as a variable annuity. The differences between the two types of investments can sometimes be subtle, and in some cases a variable annuity and an IRA can be combined in a single investment. However, there are notable differences between the two as to how funds can be invested and the income-tax implications.
Variable Annuity Definition
An annuity investment is a contractual agreement you enter into with an insurance company. These agreements require you to pay the insurance company a specified amount of money in exchange for future payments that typically begin when you retire, and which continue for a fixed number of years or for the rest of your life. What makes an annuity variable is the fact that the amount of each future payment is unknown since it depends entirely on the performance of the annuity’s investments.
Annuities and IRAs share some characteristics in that both investment are commonly used for retirement planning and can invest in similar types of securities, such as mutual funds, corporate stocks and bonds. However, unlike a variable annuity, your initial investments into an IRA are often tax deductible. Moreover, the maximum amount you can contribute to an IRA each year is capped at annual limits set by the IRS, which are relatively low -- in 2012 they stood at $5,000 per year, or $6,000 if you are 50 or older. That means you contribute money to the IRA account over time, whereas variable annuity investments allow you to make one lump-sum investment at the outset.
Variable Annuity Taxation
The funds you use to purchase a variable annuity are not tax deductible, and therefore there is no limit on the amount you can invest. When you begin taking payments from the variable annuity, you only pay income tax on the amount of each payment that constitutes investment earnings. This is because the IRS allows you to recover your cost, or total investment in the annuity without paying taxes on it a second time. Your earnings on an annuity, which grow tax free just as they do inside an IRA, are taxed upon withdrawal.
Traditional & Roth Taxation
Most of the defining characteristics of an IRA relate to the income tax implications of the investment. Two of the most common types of IRAs are the traditional and Roth IRA. With a traditional IRA, the IRS allows you to make tax deductible contributions to the account each year, which means you don’t pay income tax on the money used to make deposits. As the investment earns income during your pre-retirement years, it accumulates in the account tax free. But when you begin making withdrawals, which the IRS requires once you reach the age of 70 1/2, you then need to report each withdrawal as income on your tax return. Roth IRAs also provide you with tax savings, but in the opposite way. Instead of deducting your contributions, you make deposits with after-tax money. But when you start making withdrawals during retirement, you don’t pay any tax on the payments. Additionally, the IRS doesn’t require you to start taking money out of a Roth IRA upon reaching a certain age like it does with traditional IRAs.
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