Annuities inside retirement accounts defeat their own purpose

An annuity is a contract where you give an insurance company a lump sum of money, and they promise to pay you a steady income for life (or a set number of years). The main reason people buy annuities is the tax break: you do not pay income tax on the growth until you withdraw the money. But if you buy an annuity inside an IRA or 401(k), you already have that tax break. You are paying for a feature you already own, which means you are spending money on something that does nothing for you.

This is the core issue. An IRA or 401(k) is already a tax-advantaged account — your money grows without being taxed each year, and you only pay tax when you take it out. An annuity's main selling point is that same tax deferral. Putting one inside the other is like buying a waterproof case for a phone that is already waterproof. You pay the annuity company's fees for a benefit that your account already provides.

Key Takeaways

  • IRAs and 401(k)s already defer taxes on growth, so an annuity's primary advantage does not add anything new inside these accounts.
  • Annuities charge fees that can range from 0.5% to 3% or more per year, plus surrender charges if you need to withdraw early, and these costs reduce your retirement savings.
  • If you want may provide lifetime income in retirement, you can often get it more cheaply through a straightforward when ready annuity outside your IRA, or by using part of your IRA balance to buy one.
  • Some variable annuities sold inside IRAs include expensive riders (add-on features) that promise income guarantees, but the same guarantees are available elsewhere at lower cost.

What you are actually paying for when you buy an annuity inside an IRA

When an insurance agent pitches an annuity for your IRA, they are usually selling you one of two things: a variable annuity with income riders, or a fixed annuity. Both come with costs that eat into your savings.

A variable annuity lets you invest in mutual fund-like options, but it charges a mortality and expense fee (usually 1% to 1.5% per year) just for the insurance wrapper. If you add an income rider — a may provide that you can withdraw a certain percentage of your money each year for life — that rider costs another 0.5% to 1.5% per year. A fixed annuity promises a set interest rate but charges surrender charges: if you need your money back in the first 5 to 10 years, the insurance company keeps a percentage (sometimes 5% to 10% of what you withdraw). Inside an IRA, you cannot access your money penalty-free until age 59½ anyway, so those surrender charges trap you further.

None of these costs buy you the tax deferral you are already paying for with your IRA. They buy you insurance features — a may provide that you will not outlive your money, or that your income will not drop if the market falls. Those are real benefits, but they cost real money, and there are cheaper ways to get them.

How to get may provide income without overpaying

If what you actually want is the peace of mind of a may provide income stream in retirement, you have options that cost less than an annuity inside your IRA.

The simplest is an when ready annuity bought outside your IRA, using money you have already withdrawn and paid tax on. You give the insurance company a lump sum — say, $100,000 — and they send you a monthly check for life. You pay no annual fees, no riders, no surrender charges. The insurance company takes its profit from the difference between what you paid and what they expect to pay you over your lifetime. That is it. The cost is lower because you are not paying for tax deferral (you already paid tax when you withdrew the money) and you are not paying for ongoing management.

Another option: leave most of your IRA invested in low-cost index funds or bonds, and use a portion of it to buy a smaller when ready annuity. This gives you a may provide floor — a minimum amount you know you will receive each month — while the rest of your money stays invested and can grow. This approach costs less than filling your entire IRA with an annuity, and it gives you flexibility if you need access to the rest of your savings.

A third option: if you have a 401(k) through your employer, some plans now offer in-plan annuities. These are when ready annuities you can buy directly from your plan, often at lower cost than buying from an insurance agent, because the plan has already negotiated rates with the insurance company.

When an annuity inside an IRA might make sense

There are narrow situations where it can make sense, though they are rare and usually involve specific employer plans rather than individual IRAs.

If your 401(k) offers an in-plan when ready annuity at a very low cost, and you want to lock in a may provide income stream without leaving the plan, that can be reasonable. The cost is lower than buying from an insurance agent, and you avoid the step of withdrawing money and paying tax on it first.

If you have a very large IRA and you are worried about outliving your money, and you want to may provide a portion of your income for life, a small when ready annuity inside the IRA might be worth the cost — but only if you compare it to buying the same annuity outside the IRA first. Run the numbers both ways. Often the outside option is cheaper because you avoid the IRA's annual fees and surrender charges.

If an insurance agent is pushing a variable annuity with income riders inside your IRA, stop. The riders are expensive, and you can get the same income may provide from a straightforward when ready annuity at a fraction of the cost.

The math: what those fees actually cost you

Fees that seem small add up fast over decades. Suppose you have a $200,000 IRA and you buy a variable annuity with an income rider. You are paying roughly 2% per year in combined fees (1% mortality and expense, 1% for the rider). That is $4,000 in year one. Over 20 years, assuming 5% annual growth before fees, those fees cost you roughly $100,000 in lost growth — money that could have been yours in retirement.

Compare that to an when ready annuity bought outside your IRA. You withdraw $50,000 from your IRA, pay income tax on it (let us say 22%, or $11,000), and use the remaining $39,000 to buy an when ready annuity. You pay no annual fees. The insurance company gives you a monthly check for life. Your remaining $150,000 stays in your IRA, invested in low-cost index funds at 0.05% to 0.20% per year in fees. Over 20 years, that $150,000 grows to roughly $388,000 (at 5% annual growth). Add your annuity payments, and you have both may provide income and growth. The total cost of this approach is the $11,000 in taxes you paid upfront — a one-time cost, not an ongoing drain.

Questions to ask before you buy

If someone is trying to sell you an annuity for your IRA, ask these questions:

What problem does this solve that my IRA does not already solve? If the answer is "tax deferral," walk away. Your IRA already does that. If the answer is "may provide income," ask the next question.

What does this cost per year, in dollars and as a percentage? Demand a written breakdown of all fees: mortality and expense, riders, administrative costs, everything. If the agent cannot or will not give you a number, that is a red flag.

What happens if I need my money before retirement? Ask about surrender charges. If there is a 7% surrender charge and you need $10,000 in year three, you lose $700. That is real money.

Can I get the same may provide outside my IRA for less? Get a quote for an when ready annuity from at least two insurance companies, bought outside your IRA. Compare the total cost (including taxes on the withdrawal) to the cost of the annuity inside your IRA. Usually the outside option wins.

Frequently Asked Questions

Can I move an annuity out of my IRA if I change my mind?

You can, but it is complicated. If you withdraw the annuity contract itself, you owe income tax on any growth, and you may owe surrender charges to the insurance company. If you want out, talk to a tax professional before you move anything. Some annuities have surrender periods of 5 to 10 years, meaning you cannot exit without a penalty.

Is a fixed annuity inside an IRA ever worth it?

Rarely. A fixed annuity promises a set interest rate, but you can get a similar may provide from a CD or Treasury bond outside your IRA, without the surrender charges. If you want may provide income, an when ready annuity is cheaper. If you want may provide growth, a CD is simpler.

What if my employer's 401(k) offers an annuity option?

Some plans offer in-plan when ready annuities at negotiated rates, which can be cheaper than buying from an agent. If your plan offers this, get the cost in writing and compare it to buying an when ready annuity outside the plan. If the in-plan option is significantly cheaper, it may be worth considering.

Do I need an annuity at all if I have an IRA?

Not necessarily. Many people retire comfortably by investing their IRA in a mix of stocks and bonds, and withdrawing a steady amount each year. An annuity is one tool for people who want a may provide they will not outlive their money, but it is not the only tool, and it is not right for everyone.

What should I do instead of buying an annuity in my IRA?

Consider a mix: keep most of your IRA invested in low-cost index funds, and if you want may provide income, buy a small when ready annuity outside your IRA using money you have already withdrawn. This gives you both growth potential and a safety floor, without paying for features you already have.