We are writing a lot of content lately based on client and reader feedback. This one is a little different for us, however. We are asked which is better…annuity vs IRA. The truth is, we are pretty well versed in IRA’s but knew very little about annuities (at least before we did the research here). With over 50% of the country currently having zero in their savings accounts, this might be a pretty opportune time to write about retirement accounts as individuals should ALWAYS be saving for retirement. We will spend the rest of this article stating the facts about annuity vs IRA and will see which one is better.
Annuity vs IRA…IRA Time
There are actually quite a few types of IRA’s besides the most common ones like the traditional and the Roth, but we will spend most of our time speaking about these two. The benefits of IRA’s are pretty simple, once the money is in the account it gets to grow tax-free. If you make $10,000 in 2017 in your IRA, you do not have to pay taxes on those gains. No bad.
Usually, we like to talk about the good first then onto the bad. But for this post, we would like to speak about the downside of IRA’s before getting into all of the good. There are a few things here to watch.
The regulators (who have never made a trade in their lives) do not allow any position to be placed in a retirement account that is not cash secured. This means a few things:
- There is no margin in retirement accounts. You cannot trade or invest with any leverage.
- You cannot trade uncovered options. Meaning, you can sell naked puts but you sure as hell cannot sell naked calls.
While this is seemingly great and makes a lot of people in the government sleep well at night, this make it far more difficult to make any real money when compared to an individual account where there is leverage and the ability to make any trade. In not allowing these things in a retirement account it is almost like the regulators are saying, “Hey, we want to make it hard for you to lose your retirement while at the same time make it hard for you to make any money in your retirement account too.”
On the other hand, the good parts of retirement accounts and specifically IRA’s are the fact that:
- There are tax deductions
- The money does get to grow tax-free…assuming you do make any money in the account that is
- In certain types of account, withdrawls are not taxed
With all this in mind, let’s talk about the two main IRA’s:
For a traditional IRA, we are able to contribute $5500 a year if we are under 50 years old and up to $6500 if we are over 50 years old to the account. This contribution can be taken as a tax deduction unless the following criteria are met:
- If you are an individual and make over $72,000 a year
- If you are married and together make over $118,000 a year
That sucks. Now you are pretty much able to continually contribute to this account without taking the tax deduction if you make more than the above numbers but with not being able to take the tax deduction, it isn’t worth the money growing tax-free as you are unable to trade the same way you would in an individual account.
When you are able to begin withdrawing from this tradition IRA, the money you take out is taxed as ordinary income. The thought behind this is when you are retired you will be in a lower tax bracket than you were when you were in the prime of your working career. Makes sense.
A Roth IRA is a little bit different. Same contribution amounts with $5500 for those under 50 and $6500 for those above 50. The contributions in a Roth IRA cannot be taken as a tax deduction like it can be for a traditional IRA. With a traditional IRA, pretty much anyone can contribute the only thing is that if your income is over a certain point the contribution does not become tax deductible. However for a Roth IRA, once your income is over a certain limit, you cannot contribute any longer. Here are the limits:
- If you are an individual and make over $132,000
- If you are married and together make over $194,000
The benefit to a Roth IRA is that when withdrawals begin in retirement, the money is not taxed at all. The way to think about it is that it is taxed ahead of time as you are unable to deduct the contribution. But the downside, besides the inability to place every type of trade, is that contributions completely stop at a certain level.
Annuity vs IRA…Annuity Time
Full disclosure, I knew close to nothing about annuities before this.
In short, an annuity is a contract between the purchaser of the annuity and a third party, typically an insurance company or in some cases a bank. In exchange for a large one-time payment, the issuer promises to do some of the following four things:
- Provide income to the buyer for a certain period of time or the full extent of the buyers’ life
- Grow assets
- Provide death benefits
- Provide long-term care
In the annuity world, there are apparently two types of annuities, fixed and variable.
There are four types of fixed annuities, all with their pro’s and con’s:
- Immediate Annuity – annuities in which the insurer starts paying out income immediately
- Defer Annuity – annuities in which the insurer starts paying out income down the road
- Multi Year Guarantee Annuity – annuities where the insurer pays a fixed interest rate for a certain period of time. This is very close to just purchasing a bond
- Indexed Annuity – annuities that increase or decrease in value depending on the performance of the equity indexes such as the S&P 500 or the Dow Jones Industrial Average
Obviously, the key here is that the income in fixed and guaranteed by the insurer. I guess it’s safe to say that these fixed annuities are good for those who are more conservative and do not do well with fluctuating returns.
Variable annuities are pretty much no different that IRA’s. Variable here means fluctuating where the income payouts are tied to the appreciation or depreciation of the value of the annuity. You can think of these as like a dividend stock, only when the stock goes higher the dividend payout is more (it isn’t in real life but we are just trying to paint a picture here people).
Obviously, the income payouts are and can be higher with variable annuities as compared to the fixed annuity. Just like in life, if you want to make more money you probably need to be able to tolerate a little more risk. One of the downsides of variable annuities are the commissions and management fees for those who manage these annuities are much larger than buying or selling stock yourself as the insurance component requires more cost.
Annuity vs IRA…What Should We Do?
Well for starters, if you want greater potential returns, take any type of IRA over a variable annuity. The fees are going to be crazy high and in an IRA the money earned (again, assuming you do make money in your IRA) will grow tax-free.
On the other hand, if you want consistent payouts and are considering getting a fixed annuity, I would compare the interest rates/payouts to that of purchasing government or municipality bonds. Since buying a fixed annuity is pretty much the same thing as buying a bond, I’d prefer to take the risk of purchasing a government-backed bond over some annuity from some insurance company that has no idea how to manage money at all. Take a look at AIG back in 2008. The 100 billion dollar insurance company decided it was a good idea to insure everyone and their mother and what happened? Their creditors got killed and the government had to swoop in and keep them afloat.
Now, what about IRA’s. Well, we recommend getting a traditional IRA and a Roth IRA. Why might you ask? We for starters, we recommend getting a traditional IRA and contribute to that account only as long as you can receive a tax deduction for your contributions. As soon as your income level prevents you from getting a deduction for your traditional IRA contribution, no longer contribute and let your earnings grow tax-free. We also recommend getting a Roth IRA and contributing the max every single year until you are no longer able to contribute.
Having both of these accounts allows the following scenario to happen. We get some deduction (traditional IRA) upfront while having some taxless income (Roth IRA) when it is time to withdraw from these accounts. All the meantime, we are loading up these account to where the benefits are maxed and out money gets to grow tax-free from the time we contribute to the time we withdraw.
Like anything else in the markets, let’s break it down and think logically here folks. Annuities sound like shit and if you can get more interest from buying a bond you should do that. At the same time, max out all of the benefits from IRA’s and let your money grow tax-free.
In short…in the battle of annuity vs IRA…IRA kicks the crap out of annuity. No wonder nobody cares about them.