One of the interesting debates in the financial industry today is the proper role and use of annuities in one’s financial situation. A subset of this discussion is the use of annuities within an IRA, an approach which is quite different from owning an annuity outside an IRA. You may be considering whether to use some of the funds in your IRA to purchase an annuity and may want to better understand the advantages and disadvantages without depending on a salesperson to tell you what you should decide.
Annuities held within an IRA – a qualified retirement plan asset – are themselves termed qualified annuities because of their location. The annuity, like other assets within an IRA, will benefit from tax deferral until distributions are made to the IRA owner. Of course, annuities held outside an IRA – non-qualified annuities – also have tax deferral benefits and, if tax deferral was one’s only goal, there would be no good reason to own an annuity in an IRA.
That said, in the current world of annuities there may be a compelling reason to own an annuity in your IRA. Annuities today go far beyond the more traditional immediate and fixed annuities and include variable annuities and indexed annuities that come in many flavors. These annuities may offer a variety of guaranteed minimum income or withdrawal and downside protection riders which provide some certainty to the owner in planning how to address retirement spending needs while protecting against market fluctuation and loss.
So how do we decide whether that annuity is right for us to purchase in an IRA? As in most investment decisions, a starting point is to know what it is you want to get from the investment and why. It is also important to understand the costs and limitations associated with the investment. Some points to address include:
When will you need to access the money to fund your goals? In an IRA, you are not required to take distributions prior to attaining age 70 ½ and may take penalty free distributions beginning at age 59 ½ (and sometimes even earlier). So if you are a younger investor, the IRA money won’t be readily available for goals arising prior to age 59 ½. For most of us, deferring distributions is the norm and that allows the IRA to potentially grow over time, depending on the investments therein. Early annuitization or a partial distribution of funds from an annuity won’t be attractive in an IRA because of penalties, fees and taxes.
Is your primary goal to achieve growth in your IRA? Many investments are available to IRAs which offer significant growth (or loss) potential. Although deferred variable annuities offer the potential for growth, you will have plenty of other investment choices which are typically less expensive than annuities. In addition, many annuities limit the investments available within the contract just as some 401(k) plans limit the choices of the participants.
Do you seek a guaranteed stream of income for retirement? Many annuity products currently available offer a variety of approaches which will allow you a predictable flow of income which will last for your lifetime and sometimes longer, depending on how the annuity is structured. You could simply plan on taking regular withdrawals from whatever assets are in your IRA, but outside of the annuity construct, you remain exposed to market risk. Annuities are a very good choice for a guaranteed stream of income inside or outside of an IRA.
Do you wish to retain flexibility and control over the investments in your IRA? Typically, an IRA owner can buy and sell various investments inside the IRA and because of the tax deferral offered in an IRA, there will be no immediate tax consequences when investments are bought or sold. This also applies to annuities to some extent, at least where the owner chooses to change investments held by the annuity as opposed to exiting the annuity altogether. In addition, there are strong incentives to own an annuity in an IRA where it can provide protection against downside risk together with upside potential and the equity indexed annuity is a good match for this goal.
Do you expect to have your IRA pass to a surviving spouse or other heirs upon your death? When an IRA is a significant asset for a person, there is often the intent that the funds are going to be made available to specific persons, usually family members, upon the IRA owner’s death, particularly when death occurs at a younger age. However, the terms of the annuity with regard to any survivor benefit or death benefit will be controlling as to that portion of the IRA.
What other flexibility or limitations apply with an annuity in an IRA? One interesting aspect of the annuity in an IRA is the possibility of the contract providing for a joint and survivor benefit even though the IRA belongs to one person and is never itself a joint asset. This feature provides a means of ensuring continuity of the annuity in the IRA even after the owner’s death and can be useful particularly for survivor needs. A less desirable feature of an annuity contract is the lengthy time frame during which surrender charges will be imposed if you wish to exit the contract. These charges are quite apart from the tax deferral and other related aspects inherent in an IRA and instead the charges are directly related to the annuity product itself. This limitation may discourage investment in an annuity but should be a point of discussion when considering any annuity.
Apart from these questions about how you intend to use your IRA, it is important to understand how the annuity works in terms of the distributions made to the IRA owner. The simplest approach is the immediate annuity, including an annuity once annuitized, since the stream of annuity payments will satisfy the required minimum distribution for the annuity. If only a portion of the IRA is invested in an annuity, then only the RMD for the annuity portion is covered by these distributions. The RMD will need to be calculated and paid separately for the remainder of the IRA.
Similarly, the money you invest in a qualified longevity annuity contract or QLAC, is not considered when you are calculating the RMD for the remainder of the funds in the IRA. The QLAC is limited to the lower of 25% of the IRA balance or $125,000 and typically is set to commence distributions at a much later age, often in the mid-80s, to help provide against the needs occurring with a longer than expected life. There must be distributions at the age stated in the contract, but the RMD requirement is not applicable.
It is with the variable annuity products that the distributions become somewhat more complex. Much depends on whether the annuity has been annuitized. If the annuity has not been annuitized, then its value must be used, along with the rest of the assets in the IRA, to determine the RMD. The RMD may, of course, be satisfied by a distribution from other assets and does not necessarily have to come from the annuity. Once annuitized, as noted above, the annuity payments will satisfy the RMD for the annuity portion of the IRA. Note that calculation of the RMD depends on the account balance at the end of the prior year so that care should be taken in determining both the RMD and the source of payments. If an annuity payment exceeds the RMD for the annuity portion of an IRA, the excess may not be applicable to the RMD on the balance.
So back to the original question – should you own an annuity in your IRA? Perhaps, depending on your needs and goals and the specific attributes of the annuity you may be considering. Ask an objective and informed person who is not going to benefit from your decision. That means don’t just listen to the annuity salesperson or insurance company but seek advice from an independent professional.
George Chamberlin & Mentor RIA Consulting © 2019