Whether you agree with their use or not, annuities have become popular investment vehicles for IRA and Roth IRA owners alike. Despite the fact that there is no additional tax benefit to holding an annuity inside an IRA, many of today’s annuity contracts offer certain benefits or guarantees that appeal to clients.
Like many aspects of IRA planning, however, there are certain “gotchas” and traps associated with IRA annuities that advisors must be aware of to properly guide clients. Here is a quick look at three of those traps that relate specifically to required minimum distributions (RMDs), failure to avoid any of which could lead to a 50 percent missed RMD penalty.
Using the wrong value to calculate RMDs
Calculating a client’s RMD should be easy. You simply divide the prior year-end balance by the client’s applicable lifetime factor.
In respect to annuities, though, determining the appropriate year-end balance can be tricky. The year-end balance used to calculate an RMD for a deferred IRA annuity (that’s not a qualifying longevity annuity contract (QLAC)) should be the fair market value (FMV) of the annuity.
But many deferred annuities today have different values associated with them that can complicate matters. For instance, many annuities have an accumulation value that might represent the fair value of the assets held within the annuity (this might differ from the fair value of the entire annuity).
There may also be a separate value tied to an added benefit, sometimes referred to as the benefit base or rider value. Depending on your client’s situation, neither of these values might be acceptable for an IRA valuation.
Ron holds a deferred annuity in his traditional IRA that, after a significant market decline, has an accumulated value of $20,000. Ron’s annuity also has a rider that promises to pay him $10,000 a year for life if he begins to take distributions from his annuity.
Clearly the annuity rider has value. So while $20,000 may be the amount of money Ron can withdraw from his contract in one lump-sum, it’s not the fair market value of his annuity.
In this case, it’s easy to see that the fair market value will be some value higher than the $20,000 accumulation value. But how much higher?
Arriving at a value the IRS will accept is not so easy and often involves advanced calculations such as the interpolated terminal reserve. This is, as they say on TV, one of those “don’t try this at home” situations.
Instead, you should put the onus on the insurance company issuing the annuity to provide the fair market value. After all, the insurance company will have to report that value to the IRS on Form 5498 anyway.
RMDs after an IRA is annuitized
This trap applies to annuities that have been annuitized (i.e., when the stream of distributions under the contract begin). In such cases, a client makes an irrevocable election to receive a guaranteed income stream over a number of years, a lifetime, or a joint lifetime.
One common question both clients and advisors ask is, “How will RMDs be calculated after the annuitization?” If Ron has, say, only one IRA, with a $100,000 balance, the RMD answer is simple: The annuitized amount that comes out of the IRA each year satisfies Ron’s RMD obligation.