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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.