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Forever and a day, the rule of thumb has been that you should not use IRA funds to purchase an annuity – primarily because traditional annuities had the primary feature of tax deferral. Since an IRA is already tax-deferred, it’s duplication of effort plus a not insignificant additional cost to include an annuity in an IRA. This hasn’t stopped enthusiastic sales approaches by annuity companies – plus new features may make it a more realistic approach.
Changes in the annuity landscape have made some inroads against this rule of thumb – including guaranteed living benefit riders, death benefits, and other options. Recently the IRS made a change to its rules regarding IRAs and annuities that will likely make the use of annuities even more popular in IRAs: The use of the lesser of 25% or $125,000 of the IRA balance (also applies to 401(k) and other qualified retirement plans) for the purchase of “longevity insurance”, which is another term for a deferred annuity.
Under the new rules, an IRA owner could purchase a deferred annuity (meaning the annuity begins paying the holder at some deferred date, such as age 80) and eliminate the value of the funds used to purchase the annuity when calculating Required Minimum Distributions from the account.
An example of this in action would be for an individual who has an IRA with a balance of $500,000 and who is approaching age 70½, when Required Minimum Distributions will be required. This individual could set aside $125,000 in an annuity that begins payout at his age 80 for a guaranteed 10-year payout period. This would provide a fixed payout of approximately $18,000 to the individual in ten years. (Note: This payout amount is not much more than a wild guess. I don’t deal in annuities regularly so I can’t vouch for the efficacy of this estimate.)
By doing this, he could reduce his Required Minimum Distributions by 25% during the coming ten years, and then have the fixed payment in addition to his RMDs at age 80.
One of the primary downsides to annuity ownership is the internal cost of the policy – typically 2-3% annually before any underlying fund costs. For this cost, the insurance company agrees to pay the annuitant a particular sum of money for the annuitant’s life, guaranteed. In addition, an annuity typically ties up your money or at best penalizes you heavily in the first years of the policy with significant surrender expenses (often 8% or higher, reducing as years pass). Some additional policy riders can provide death benefits, guaranteed payout periods (providing a payout no matter how long the annuitant lives) and other features which may make it more suited to your needs. It’s up to you whether or not the benefit is worth the extra cost and potential penalties.
There are annuity providers who charge much lower annual fees for annuities. If you’re interested in this kind of income guarantee, you would do well to seek out a lower-cost option in order to keep the drag on your overall portfolio to a minimum. In addition, you might look at fixed annuities rather than variable annuities, utilizing the fixed payout nature of these policies as a proxy for a portion of your bond portfolio. Fixed annuities are typically lower cost than the equity-based annuities, and the deferred annuity payments are typically guaranteed amounts.
I’m not ready to start recommending annuities to clients on a regular basis, don’t get me wrong. Annuities have always been a tool available for guaranteeing an income stream of some variety, but any recommendation would generally be based upon the retiree’s circumstances being such that the resources available are not enough to support the future income needs, where there is an extreme concern over the potential of running out of money during one’s lifetime. This change to the rules of annuities in IRAs may help to ease the stresses on your portfolio.
Sterling Raskie, MSFS, CFP®, ChFC®
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Another point is an annuity is never totally guaranteed because the payout is dependent upon the strength of the underlying company.
Although I’ve never been a fan of variable annuities, I’ve noticed three areas where the popular press seems to have so far gotten it wrong:
(1) variable annuity companies even with their fees haven’t actually made much money and some are leaving the business such as Hartford (although today’s new variable annuities may now be less consumer friendly and better for the insurance companies)
(2) older clients in nursing homes with high medical expenses can often withdraw ordinary income from an annuity with little or no tax hit to pay high nursing home costs so the expected ordinary income hit may not materialize; and
(3) many of the old variable annuities have a fixed option with a guaranteed 3% or higher return, which could be attractive to some clients in today’s low interest rate world. Before surrendering it’s always worth checking the fixed option, especially if a client has other money sitting near 0%.
Jim, I agree that many commentators have said that it is foolish to put an annuity inside an IRA because “it’s a waste of tax deferral”. The problem with that argument is that it is simply wrong. The tax treatment that applies to an annuity – or any other investment instrument – if held in a taxable account is totally irrelevant to the suitability of that instrument if held in a tax-deferred account.
For example, the gain on a small non-dividend paying stock (or mutual fund investing in such stocks) will, if it’s held over one year, be taxed at Long Term Capital Gains rate. But if that same stock or fund is held in a tax-deferred account, all gain will be taxed as Ordinary Income (a higher rate). The logic that holds that the tax deferred treatment enjoyed by a nonqualified annuity is “wasted” if the annuity is held inside a tax-deferred account would say that the long-term capital gains treatment enjoyed by that stock or fund is similarly wasted if that instrument is held in a tax-deferred account. Thus, if one shouldn’t hold an annuity inside an IRA because of the supposed “tax wastage”, one shouldn’t hold a small cap stock in there either.
But no competent investment advisor would ever make such a suggestion because there are clearly reasons why a particular taxpayer might want the asset allocation in her IRA to include small cap stocks- reasons that have nothing to do with how those stocks would be taxed if she held them outside the IRA.
As you point out, annuities – both the deferred and immediate – provide guaranteed income. If guaranteed income, perhaps for life, is an important investment objective for a particular taxpayer, then some form of annuity may be appropriate.
Speaking strictly for myself, I don’t much care for using variable deferred annuities outside tax-deferred accounts because the “all Ordinary Income” treatment that applies to all distributions from all annuities, together with the possibility of a 10% penalty tax, is, in my judgment, rarely worth the advantage offered by tax deferral.
A nonvariable deferred annuity held in a taxable account does not suffer from the “ORDINARY Income” treatment because investment alternatives properly comparable to fixed annuities also generate Ordinary Income treatment.
Moreover, one need not invest in a variable deferred annuity to get equity returns and tax deferral. One can do that by buying stock or stock mutual funds and holding them. The gain in stock price or fund net asset value will not be taxed until it is distributed.
I am neither “for” nor “against” using annuities – either immediate or deferred – inside tax-deferred accounts. I am against blanket condemnations of this practice that rely upon bad logic and a misunderstanding of how tax treatment affects suitability.
Thanks for the input John. I hope you don’t think my article was a blanket condemnation of annuities inside IRAs (that was not my point at all). My point is that in some cases an annuity may make sense in an IRA, and the recent move by the IRS can be yet another reason that this might make sense.
Very rarely can one defer taxes in a mutual fund. Even if you never sell, you will pay taxes on the distributions made in the fund. These include long term and short term gains, as well as dividends. Some funds have low turnover, so taxes may e lower, but they still gave taxes.
In the right situation a fixed annuity inside an IRA could be entirely appropriate but variable annuity guaranteed benefits are terribly expensive and the client may never use them.
Couldn’t agree more, Buz. That’s part of the point I was trying to make – you said it much better! :)