Should annuities ever go into an IRA?
August 8, 2014 by Julius Giarmarco
Internal Revenue Code Section 72 provides annuities with a tax preference in the form of tax-deferred growth. Similarly, IRAs enjoy tax-deferred growth. Thus, given the similarities between IRAs and annuities, should an IRA ever purchase an annuity? Obviously, if the only purpose of the annuity is tax-deferred growth, the answer is “no.” The reason is the additional expenses associated with annuities (see below).
However, in the early 2000s, annuity carriers added new riders to their variable annuities, such as guaranteed living benefits, enhanced death benefits and unique investment features (equity-indexed annuities). And, with certain fixed annuities, superior fixed income yields. Given these guarantees, having an IRA purchase an annuity may make sense for some IRA owners. Risk-adverse individuals, in particular, may find that the guarantees associated with annuities offer them the security they desire. In fact, according to the Investment Company Institute, 35 percent of households with IRAs have annuities in their IRAs.
Another situation in which it might make sense to mix an annuity with an IRA is to manage required minimum distributions (RMDs) (so that penalties are avoided) while assuring income lasts a lifetime. By purchasing an immediate annuity about the time RMDs must begin, the carrier takes care of the RMD compliance and guarantees that the payments will continue for the chosen period (e.g., the IRA owner’s life or the joint life of the IRA owner and his/her spouse). Of course, the IRA annuity must meet the RMD rules.
Depending on the type of annuity, the annual distributions may be larger than the RMD if the IRA owner did not buy an annuity. One downside to this approach is less flexibility. If an emergency arises, the IRA owner’s ability to draw additional funds from the annuity is limited. Another downside to an immediate annuity is that the payments are fixed. They do not increase with inflation.
While some inflation–indexed annuities are available, they have lower initial payouts. An immediate annuity also works best for IRA owners who have no beneficiary to whom to leave their IRA, since the payments cease upon the death of the IRA owner (or the death of the survivor of the IRA owner and his/her spouse, if a joint and survivor annuity is purchased).
A recent development for retirement annuities is the qualifying longevity annuity contract (QLAC). On July 1, 2014, the IRS released final regulations that make QLACs (first introduced in 2012) more attractive. The QLAC is a close cousin to the immediate annuity. The basic concept of a QLAC is simple: Rather than purchasing an immediate annuity in your IRA at age 65 to start receiving income right away, you purchase an annuity for an income stream that will start if and when you reach age 85. Of course, if a 65-year-old wants to have income start at age 85, this conflicts with the RMD rules which require that distributions commence at age 70½. The new regulations solve this problem by excluding the value of the QLAC from the account balance used to calculate the RMD. In other words, a QLAC automatically complies with the RMD rules — even though payments will start well after age 70½.
Payments from a QLAC must begin no later than the first day of the month after the participant turns age 85. While the QLAC may have a cost-of-living adjustment, it cannot be a variable or equity-indexed contract, and it cannot offer any cash surrender value. In addition, the amount you’re allowed to invest in a QLAC is limited to the lesser of 25 percent of the IRA balance, or $125,000. The regulations also allow a QLAC to pay benefits in the event the participant dies before reaching the age that payments start. In such event, the payments can be made to a named beneficiary (such as the participant’s spouse), or a “return of premium” death benefit can refund the premiums paid upon the participant’s death. However, choosing these options will reduce the amount of retirement income the participant would receive if he/she lives to the age the income begins.
Just like other investments — good and bad — annuities have fees and expenses. These costs include commissions paid to the salesperson, mortality and expense insurance charges (i.e., the fee the carrier charges for guaranteed death benefits and guaranteed income for life), investment management fees (similar to management fees on mutual funds), and surrender charges for early withdrawals (typically between 5 percent and 10 percent). These fees and expenses mean that annuities are not meant for the short-term investor. But these fees and expenses may be well worth the added costs if the participant’s situation and planning needs warrant a rider that provides guaranteed income and/or a guaranteed death benefit.
To preserve the tax deferral when using IRA assets to purchase an annuity, you have two choices. The first is to withdraw the money from the IRA and roll it over (within 60 days) to the individual retirement annuity. The other is to do a “trustee-to-trustee rollover”, whereby the assets are transferred straight from the IRA to the annuity.
Finally, when having an IRA own an annuity, keep in mind that the annuity must be valued for Roth IRA conversions and RMDs. The reported value of the annuity may not be the appropriate number. The reason is that riders guaranteeing a death benefit, current income, and/or a guaranteed base of income in the future have value. These values must be considered in valuing the annuity for purposes of a Roth conversion or RMDs. The best course of action is to ask the carrier for the value of the annuity before making a Roth conversion or taking an RMD.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISERS AS TO THEIR SPECIFIC SITUATION.
