Can an Annuity Be a Good Investment Inside an IRA? Yes—but Not for the Tax Deferral

Search the internet for information about annuities inside IRAs, and you are likely to encounter some version of this warning:

“Never put an annuity inside an IRA because the IRA is already tax-deferred.”

There is an important truth buried in that statement.

There is also an important misunderstanding.

An annuity purchased inside an IRA, 401(k), or other tax-qualified retirement plan generally provides no additional income-tax deferral beyond what the retirement account already provides. FINRA states this explicitly: an annuity held within an IRA or 401(k) provides no additional tax advantage from its tax-deferred status.

But that does not mean an annuity has no place inside an IRA.

It means tax deferral should not be the reason you put it there.

The better question is:

What does the annuity contract provide that the IRA itself does not?

And that is where the discussion becomes much more interesting.

An IRA Is a Tax Structure. An Annuity Is an Insurance Contract.

An IRA and an annuity do fundamentally different things.

An IRA is a tax-qualified retirement arrangement (not account). Among other things, it determines how contributions, earnings, distributions, and required distributions receive federal income-tax treatment.

An annuity is a contract issued by an insurance company.

When an annuity is purchased outside an IRA with after-tax money, tax deferral on its earnings can be one of its characteristics.

When that same type of contract is purchased inside a traditional IRA, however, the IRA already provides tax deferral.

The IRS confirms that an IRA can purchase an annuity contract and that taxation generally occurs when payments are ultimately received from the contract.

So putting an annuity inside an IRA does not somehow create “double tax deferral.”

There is no extra tax-deferral prize for wrapping one tax-deferred vehicle inside another.

But tax treatment is only one characteristic of an annuity contract.

What Are You Actually Buying?

This is where many discussions about annuities inside IRAs go wrong.

They begin and end with taxation.

But if an annuity is being considered for qualified retirement assets, the analysis should instead focus on the economic and contractual provisions being purchased from the insurance company.

Depending upon the particular type of annuity and contract, those provisions may include:

• Guaranteed lifetime income that cannot be outlived;

• Longevity-risk transfer, shifting some of the financial consequences of living an unusually long life to an insurance company;

• Guaranteed withdrawal benefits available under certain contracts and riders;

• Principal or downside guarantees under certain fixed or indexed annuity structures;

• Death-benefit provisions available under some contracts;

• The ability to establish a predictable income floor for essential retirement expenses;

• Contractual guarantees that are not dependent upon the retiree deciding how much to withdraw from an investment portfolio each year.

Those are insurance and risk-transfer characteristics.

They have nothing to do with obtaining additional tax deferral inside the IRA.

FINRA itself recognizes this distinction. Its guidance concerning deferred variable annuities held in IRAs specifically says that because the annuity provides no additional tax-deferred treatment, features other than tax deferral must make the annuity appropriate for the IRA owner. (This was standard disclosure language at the broker/dealer I was with 20 years ago.)

That is a much more useful way to frame the issue.

Consider Longevity Risk

Suppose someone retires with a substantial traditional IRA.

The investment question might be:

• How should these assets be invested?

But there is another question:

• What happens if this person lives to age 95 or 100?

That is not simply an investment-return problem.

It is a longevity problem.

One potential use of an annuity is to transfer some portion of that longevity risk to an insurance company. In exchange for giving up some degree of liquidity, upside potential, or control—depending upon the contract—the retiree can purchase contractual income guarantees.

That can be valuable even though the IRA was already tax-deferred.

In fact, federal tax law specifically recognizes a specialized form of qualified annuity for longevity planning: the Qualified Longevity Annuity Contract, or QLAC.

A qualifying QLAC can be purchased with certain qualified retirement assets, and its value is excluded from the account balance used to determine required minimum distributions before annuitization. Current IRS rules permit QLAC income to begin as late as age 85, subject to applicable requirements and limits.

The existence of QLAC rules illustrates an important point:

An annuity can serve a legitimate economic purpose within qualified retirement assets precisely because it is an insurance contract designed to address longevity—not because another layer of ordinary tax deferral is needed.

Guarantees Have a Cost

None of this means that every annuity belongs inside an IRA.

Far from it.

An annuity contract can contain surrender charges, expenses, limitations, caps, participation provisions, mortality and expense charges, rider costs, or other restrictions depending upon the type of contract. FINRA specifically cautions consumers to understand an annuity's fees, expenses, charges, riders, guarantees, and restrictions before purchasing one.

And different categories of annuities can have dramatically different cost structures.

The proper analysis therefore isn't:

• IRA + annuity = bad.

Nor is it:

• IRA + annuity = good.

Instead, ask:

• What am I receiving in exchange for the cost, restrictions, and liquidity I may be giving up?

If the answer is merely “tax deferral,” then there is a problem. The qualified account already provides that.

If the answer is a valuable contractual guarantee or transfer of a financial risk that the IRA owner specifically wants an insurance company to assume, the analysis is entirely different.

Don't Confuse the Container With What You Put Inside It

One useful way to think about an IRA is as a tax container.

The container establishes certain tax rules.

But the assets or contracts held within that container perform different economic functions.

• Stocks may provide ownership and growth potential.

• Bonds may provide income and relative stability.

• Cash equivalents may provide liquidity and principal stability.

• An annuity may provide contractual guarantees and transfer particular risks to an insurance company.

The fact that the container is already tax-deferred doesn't tell us which of those economic functions the owner needs.

The Question Should Be About Purpose

Before purchasing an annuity inside an IRA or other qualified retirement plan, I believe the discussion should begin with purpose.

• What problem are we trying to solve?

• Are we trying to maximize liquidity?

• Are we trying to maximize long-term accumulation?

• Are we concerned about market losses near or during retirement?

• Do we want a portion of retirement expenses supported by guaranteed income?

• Are we concerned about living substantially longer than expected?

• How much control over the assets are we willing to surrender in exchange for guarantees?

• Which risks are we willing to retain ourselves—and which risks would we rather transfer to an insurance company?

Only after answering those questions does it make sense to evaluate whether a particular annuity contract belongs inside the retirement strategy.

The Bottom Line: Annuities Inside IRAs Can Make Sense

An annuity provides no additional ordinary tax-deferral advantage when it is purchased inside an IRA or other tax-qualified retirement account.

That point isn't controversial.

But it also doesn't settle the question of whether an annuity belongs there.

An annuity should be evaluated for its inherent contractual and economic provisions: guarantees, income options, longevity protection, risk transfer, death-benefit provisions, and other features specific to the contract being considered.

If those provisions don't solve a meaningful problem, there may be little reason to incur their associated costs or restrictions.

But if they do solve an important problem, dismissing the annuity simply because “the IRA is already tax-deferred” misses the point.

Don't buy an annuity inside an IRA for additional tax deferral. There isn't any.

Buy one—when appropriate—because the annuity contract provides an economic benefit or transfers a risk that you actually want.

That is a very different decision.

This article is intended for educational purposes only and is not tax, legal, or investment advice. Annuity guarantees are subject to the claims-paying ability of the issuing insurance company. Contract provisions, charges, restrictions, surrender periods, and tax consequences vary. Consult the appropriate financial, tax, and legal professionals regarding your individual circumstances.