Should You Have A Traditional IRA Or An Individual Retirement Annuity?
Investing for retirement can be easy — you just have to do it. What's not so easy is knowing how much you should be saving, or the right investment vehicles to park your money in to maximize your potential for growth. Before getting into how much you “should” or might “need” to be saving, let’s tackle which investment vehicle might be right for you.
Outside of employer retirement plans, Three popular options Americans can elect to invest in are traditional IRAs, Roth IRAs, and individual retirement annuities. Would any of these options work for you?
Let's break down the facts on these three retirement planning accounts.
What Is a Traditional IRA?
A traditional IRA is a retirement account in which an investor can grow their principal tax-deferred. You only pay income taxes on your withdrawals when you reach retirement age. In other words, you can put pre-tax money into the IRA and this money may grow tax free UNTIL you take it out of the account, at which point you’ll pay income tax on the principal and growth.
People at all income levels can invest in traditional IRAs, exceptions apply for making pre-tax contributions, and investors must begin to make withdrawals at age 72.
Traditional IRAs as we know them today first emerged in 1974 as part of the Employee Retirement Income Security Act. Today, over 60 million taxpayers (about 29%) own an IRA of some kind, including 50% of taxpayers older than 60.
Millennials are not lagging when it comes to investing in IRAs, These young taxpayers invested $373 million in IRAs in the fourth quarter of 2020, bringing their average IRA balance for millennials to $32,700.
The higher the adjusted gross income, the greater the percentage of taxpayers who own an IRA. In fact, 73% of people earning $500,000 or more in adjusted gross income have an IRA. Presumably, a large amount of which is due to job changes and rollovers from 401(k) plans to IRA accounts. Interestingly, slightly more women than men invest in IRAs.
Most IRAs are of the traditional variety, and they also hold the most money on average. However, Roth IRAs offer a beneficial alternative for many taxpayers.
In 2017, 10% of taxpayers held a Roth. That share has probably increased since Millennial investors overwhelmingly prefer this vehicle. For good reason too...
What Makes a Roth Different from a Traditional IRA?
You contribute after-tax dollars to a Roth IRA. Your money then grows tax-free, and assuming the account’s been open for 5 years, and you can withdraw funds with no taxes or penalties after age 59 ½.
In a traditional IRA, by contrast, you can contribute either pre-tax or after-tax dollars. Your money grows tax-deferred, and you are only taxed on your withdrawals. You may withdraw from a traditional IRA at age 59 ½, and you must start annual withdrawals at age 72.
What Is an Annuity?
An annuity is a different kind of investment vehicle altogether. In an annuity, investors purchase an insurance contract through a financial institution or insurance company. This contract pays the investor a fixed amount throughout their retirement.
Annuities come in four basic types — immediate variable, immediate fixed, deferred variable, and deferred fixed. The type of annuity you have determines when you receive payments and how your annuity grows. Individual retirement annuities often only come in the form of fixed or variable annuities.
About 38% of Americans hold an annuity or a pension, and their popularity has soared in recent years. The first quarter of 2020 saw $55 billion in annuity sales.
Many investors choose annuities based on their predictable payout schedule, but there is often a drawback to this “guaranteed” payout
5 Key Ways an Annuity Differs From an IRA or a Roth
Annuities provide a fixed income for life and may offer after-death benefits to your survivors. An IRA allows you to save and grow assets overtime, creating a nest egg for your retirement.
Unlike Roth IRAs, annuities provide tax-deferred, not tax-free, growth. Investors pay taxes on the monthly checks they receive from the annuity after retirement.
Annuities typically come with very high broker fees. Some annuities charge 10% of the investment's earnings just for commission. IRAs cost very little if anything to open.
In an IRA, you risk the value of your account going down if your investments take a dive. If you have a fixed annuity, you risk inflation eating up your buying power over the course of your retirement.
Annuities are very complex insurance products.
Benefits of Annuities
In general, many investment advisors do not recommend annuities, but these assets may make sense in certain cases.
If you purchase an annuity with a death benefit rider, for example, you can divert your payments to a loved one after you pass away.
Some annuities are guaranteed, meaning if you invest $250,000, and the value of your investment account drops below $250,000, you may still get your entire principal if you cash out the annuity.
When Does an Annuity Make Sense?
If you've maxed out your 401(k), maxed out your Roth, maxed out your traditional IRA, paid off your house, and decided against investing in real estate… it might be time to consider buying an annuity.
Before you sign on the dotted line, though, let's look at some of the drawbacks to investing your future in an annuity.
Risks and Pitfalls of Individual Retirement Annuities
The potential drawbacks of annuities boil down to two:
They're very expensive.
And they rarely earn more than stocks or mutual funds.
Let's talk about expenses first.
Remember that an annuity is an insurance product. Consequently, guess who's guaranteed to make money on an annuity?
If you guessed "the insurance company that sells the annuity," you'd be right.
Most often, annuities cost a pretty penny and all those fees are going straight into the insurer's pocket. Charges can include commissions, rider charges, investment management fees, and insurance charges.
Where you really get stuck, though, is with surrender charges. If you withdraw money from your annuity before the surrender charge period is complete, you could owe big penalties to the insurance company — on top of the penalties the IRS will levy if you are younger than 59 ½and not rolling the funds over to another retirement vehicle.
Now, let's go back to earnings and growth.
Annuities provide a guaranteed income. That sounds great, but for this guarantee there’s a cost, remember the insurance company is betting the investment will earn more than your guaranteed income and the insurance company is planning on skimming off the difference.
A well-diversified mutual fund or exchange traded fund with a track record of providing market returns is you with a far more lucrative retirement income than an annuity will.
As with any other financial decision, choosing to invest in an annuity involves risk. That's why you need experts on your side. You can search "best financial planners near me," or call us at Cooke Wealth Management to make an appointment with one of our advisors.