Annuity vs. IRA: Which Is Best for My Retirement?

As you plan how to save for retirement, you'll hear about IRAs and annuities. Both can generate income later in life, have some potential tax advantages and include penalties for early withdrawals.

But beyond these similarities are differences that may make one better than the other for your situation.

What are annuities and IRAs? How do they differ?

IRA is short for individual retirement account, an account that you can use to purchase stocks, bonds, mutual funds and other assets to build a retirement nest egg. There are two main types of IRAs, traditional and Roth:

• Traditional IRA: You contribute pretax dollars — the contribution limit is $7,000 in 2024 and 2025 ($8,000 if age 50 and older). When you withdraw money in retirement, it will be taxed at your rate then, which may be lower. You’ll face penalties for any withdrawals before age 59½, and you must start taking required minimum withdrawals annually at IRS-specified ages — currently, that age is 73. It will increase to 75 in 2033.

• Roth IRA: Annual contribution limits are the same, but you put in post-tax dollars and so withdrawals in retirement aren’t taxed. It also has more leniency when it comes to early withdrawals and there aren't required minimum distributions.

An annuity is an investment baked into an insurance policy. You pay a premium, either all at once or over time. The insurer invests that cash, and in return pays you a guaranteed monthly, quarterly or annual payment starting at a specific time and lasting a set number of years or for the rest of your life. There is often a 10% penalty for withdrawal before age 59½.

Is an IRA a good choice for your retirement?

Alongside employer-sponsored plans like a 401(k), IRAs are the workhorses of modern retirement savings. For most people, an IRA is the obvious next choice once they’ve contributed to their 401(k) at least enough to get any matching dollars from their employer.

Pros:

• You have control of investment decisions and keep all the gains when your investments do well.

• You can pass an IRA to a beneficiary, such as your spouse or children.

• Fees on IRAs are lower and easier to understand than annuity fees.

• You can pick the IRA that will help your particular tax situation.

Cons:

• You have to make the investment decisions. (This primer on how to invest your IRA can help.)

• There’s no guarantee on how well your investments will do or how much money they’ll provide you in retirement.

• You need to pay attention to tax rules on how much you can put in, whether you can deduct it and when to take money out.

• You could run out of money in retirement if you don’t save enough.

» MORE: See NerdWallet’s picks for the best IRA providers

Is an annuity a good choice for your retirement?

Guaranteed payments are appealing if you’ll be paying a large fixed expense like a mortgage in retirement or if you worry about running out of money in old age.

Pros:

• You get a set payment you can count on.

• You can choose an annuity that pays until you die, or until you and your spouse have both died.

• You can choose an annuity with a death benefit, which lets you name beneficiaries to receive any unpaid funds.

• Some types of annuities can help high-income investors looking for a tax deferral who have already maxed out contributions to their 401(k) and IRA accounts.

Cons:

• Inflation can erode the buying power of a set payment amount over time.

• You have limited (or no) say in annuity investments.

• You get a set return and the insurer keeps the difference if the investments do well, although some types of annuities have payments that fluctuate depending on investment performance. Read more on that below.

• Fees are higher than IRA fees and carry potential “surrender” charges if you terminate your policy.

But perhaps the biggest drawback to annuities is their complexity.

What to know before buying an annuity

Annuities can come in a wide variety of models, with varying time frames, payment amounts and lengths. These layers of complexity can make them hard to understand.

Some different annuity types include:

• Fixed annuity: You pay a premium, then after a period of time, you get payments for a fixed dollar amount.

• Variable annuity: Allows you to choose some investment options for your premium, such as mutual and bond funds. Sometimes minimum loss or growth rates are set.

• Equity-indexed annuity: Will track to some degree a stock index like the S&P 500 and guarantee minimum interest payments.

Annuities are said to be “more sold than bought;” that is, brokers may be eager to sell annuities because they carry high commissions, rather than because they’re a great fit for the client.

It’s true with all investment choices, but especially for complex products like annuities: