For many clients, the potential downsides of annuity investing can overshadow the valuable security that these products can offer with respect to providing a guaranteed income stream for life — and often for good reason. The tax treatment of a standalone annuity, when combined with the required capital commitment, simply might not make sense for some investors. Combining an annuity investing strategy with a Roth investing strategy, however, can change the picture dramatically.
Adding a Roth IRA into the mix can eliminate or reduce the impact of the potential downsides of an annuity investing strategy—for the right client, this strategy can allow for a much more favorable future tax scenario and mitigate the negative connotations associated with investing a relatively large sum of money for the long haul.
The Combination Roth Annuity
One of the most problematic aspects of annuity investing for some clients is the eventual tax treatment of the future income stream. While annuities have positive tax attributes, the growth on the account value will eventually be taxed as ordinary income even if the client holds the investment for a substantial period of time before annuitizing the product. On the other hand, many other long-term investments will be taxed at the lower capital gains tax rate—discouraging some clients from choosing the annuity option over stock and property investments.
When an annuity is purchased with Roth IRA funds, the picture changes. The Roth IRA tax rules will govern eventual distributions from the annuity contract, so that those funds will be received tax-free in the future (because the client pays taxes on the funds he or she contributes to the Roth at the time of contribution).
Combining the annuity and the Roth allows the client to receive the lifetime income benefits offered by the annuity with the tax advantages of a Roth IRA. In order for the distributions to be received tax-free, the distribution rules that apply to Roths must be followed. This means that the investment must generally remain in the Roth for at least five years before it is withdrawn.
If the client has yet to reach age of 59 ½, withdrawals will only be partially tax-free (contributions are withdrawn tax-free, but earnings on those contributions are taxed).
The rules that govern tax-free Roth IRA distributions also address a second downfall of annuity investing—many clients shy away from annuity investing because it requires investment of a large sum of capital that the client will not be able to access without penalty, often for many years. The Roth annuity mitigates this issue because Roth IRA investments are generally long-term (they must remain in the account for at least five years in order to reap the valuable tax benefits provided by the Roth).
Because the growth on a Roth IRA investment can also be withdrawn tax-free, most clients who invest in a Roth wish to keep their funds in the account for as long as possible to maximize this tax-free growth potential. In this respect, even if the annuity has large surrender charges, it makes sense as a long-term Roth IRA investment for clients seeking out lifetime income.
While the tax benefits of the Roth annuity may be substantial, many critics argue that the expense of purchasing an annuity product in general may outweigh these benefits.
Annuities can come with guarantees and features that add to the cost of the product, so it’s important that the client carefully select the annuity to make sure that it contains only features that are valuable enough to the client so that the associated costs are justified.
Further, while the issue of surrender charges is mitigated by the fact that Roth IRA investments are generally meant to be long term, the client still needs to be made aware of the issue. If the client anticipates that the funds could be needed in an emergency before the surrender period has expired, an annuity investment may be a poor option.
The ideal candidate for a Roth annuity strategy is a client who has sufficient funds available outside of the annuity to cover reasonably anticipated expenses during the period in which surrender charges will apply.
For the right client, a Roth annuity can be a valuable alternative to traditional annuity investing—combining the powerful tax benefits of the Roth with the income security provided by an annuity can heighten the value of both investment strategies as a whole.
See these additional blog postings by Professors Bloink and Byrnes:
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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