Annuities vs IRAs vs 401ks

At no other time in our history has the need for retirement planning been more critical. Tens of millions of Baby Boomers will be crossing the retirement threshold unprepared and underfunded, and the generations that follow are not on track.  It’s beginning to hit home for people that , if a comfortable, secure retirement is to be, then it is up to thee.  And, this is why it is vitally important to have a thorough understanding of all of the tools in the arsenal. There is no “one size fits all” for retirement solutions, and there is no one single vehicle that will get the job done.  The option should no longer be framed as Annuities vs IRAs vs 401(k), but rather, Annuities + IRAs + 401(k)s as a more complete solution for retirement.

Combining the three may not be an appropriate strategy for everyone. Not everyone has access to a 401(k) plans, and for those who do, not everyone may be eligible to make a tax qualified IRA contribution. While, anyone can own an annuity, it may not always fit their financial situation.  But, where the strategy can fit, creating a retirement portfolio using some combination of these vehicles could produce the best long term results.   Let’s examine them separately, then together as a multi-pronged strategy:

The Annuity Component

Annuities are non-qualified retirement vehicles, which means that contributions are not currently tax deductible. They do, however, allow for funds to accumulate tax-deferred.  Unlike qualified plans, there are no limits to how much can be contributed to annuities, and, on the other end, there is no required minimum withdrawal (RMD).  Like their qualified plan cousins, annuities do have some restrictions on early withdrawals, prior to age 59 ½, in which the IRS will apply a 10% penalty. Additionally, annuities also have surrender penalties that are applied by the annuity provider if funds are accessed early in the accumulation phase, generally the first seven to 10 years.  The penalty, which can begin as high as 10% is reduced each year of the surrender period until it is reduced to zero.

From a retirement planning standpoint, annuities provide two primary advantages. First, the tax deferred component works to the advantage of younger people with time to accumulate. If the retirement horizon if 15 years or more, tax deferral can give savers in higher tax brackets an edge.  Secondly, annuities have an income component that can guarantee that a retiree will not outlive their income.  The amount of the income is based on the accumulated capital, the age of the retiree and his or her life expectancy. Payments can be guaranteed for a specified period of time, or a lifetime.

The IRA Component

There are two types of IRAs – traditional and Roth.  Both are tax qualified retirement plans, but each has a different tax treatment.  Both IRAs allow eligible people to make tax deductible contributions up to $5,000.  In a traditional IRA, the contribution is tax deductible, while in a Roth it is not.  In a Roth, withdrawals are exempt from taxes, while in a traditional IRA, the withdrawals are taxed as ordinary income.  The decision as to whether to invest in a traditional or Roth IRA should come down to your tax situation. If you are in a higher bracket currently, and expect to be in lower bracket in retirement, a traditional IRA could be more advantageous. Otherwise, a Roth would be more favorable for people if they expect their retirement tax bracket to be about the same as it is today. Plus, a Roth IRA has greater flexibility for people who want to make early withdrawals as contributions are the first to come out and are, therefore, not taxed, nor penalized.

Not everyone can qualify for an IRA. If you participate in an employer sponsored plan, you may not be eligible depending on your adjusted gross income. If your income is below $56,000 you can still invest in an IRA with full tax benefits.  If your income is above$66,000 (as a single filer) your contributions will not be tax deductible. Roth eligibility is a little more flexible for 401(k) participants but there are still income eligibility requirements.

The 401(k) Component

Participants in a 401(k) plan benefit from easy payroll contributions, current tax savings, tax deferred earnings, investment choices, and, in many plans, an employer matching contribution. Between the tax savings and the employer match, participants receive an instant return on their contributions, so it is always advisable to participate in a 401(k) plan. You can contribute up to $16,500 from your earnings.

Putting them Together

When putting together your retirement portfolio, your initial focus shouldn’t be on specific products or vehicles; rather it should be on what it is you really want to have happen in retirement. People looking for the highest degree of security and flexibility need to consider how different retirement components can work together.

For 401(k) participants, it is advisable to contribute the maximum eligible amount. This increases your current tax savings while boosting your ability to stay on track to your accumulation goal.  The same advice applies to those who are eligible for an IRA. In either case, these vehicles provide the best opportunity for maximum accumulation which is the most important aspect of retirement planning.

For those people who are concerned with the possibility of outliving their retirement income sources, serious consideration should be given to contributing, in addition, to an annuity, especially if you have reached the maximum level of contributions to your qualified plans.  While annuities can also be advantageous as accumulation vehicles, they provide a critical retirement planning element the qualified plans don’t – absolute future security. The guarantees that are built into annuities, such as guaranteed principal, guaranteed growth, guaranteed income, can create the essential safety net everyone needs and may have to rely upon if there is any disruption in your accumulation.

A sound retirement plan should be thought of as an overall strategy built around your specific needs, concerns, and priorities. For most people, no one vehicle can address all of their needs, but a well-conceived strategy employing multiple vehicles can almost always do so.