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.
What if, however, Ron, age 73, has two IRAs: IRA “A” and IRA “B?” IRA “A” has $100,000 and IRA “B” has $90,000, yielding a combined value of $190,000. Ron annuitizes IRA “A” over his lifetime and starts to receive $9,000 a year.
Assume that Ron would have a total RMD of around $8,000 for his IRAs this year, if he hadn’t annuitized any part of his $190,000 IRA. Will the $9,000 he receives from the annuity satisfy the total RMD for all of Ron’s IRAs for the year? Here’s where it starts to get a bit tricky.
There is some debate over whether or not such a distribution from an annuitized IRA annuity can be used to satisfy RMDs for other IRAs in the year of annuitization. On one hand, once annuitized, IRA annuities generally follow defined benefit plan (pension) rules instead of the defined contribution rules (e.g., a 401(k) plan).
That would lead you to believe the answer is no. But RMDs are based off of prior year-end balances. Since the annuitized annuity had a prior year-end balance and wasn’t annuitized at the time, that might lead you to believe yes. In light of the grayness in this area, the conservative approach is to take the $9,000 annuity distribution from IRA “A” and an additional distribution from IRA “B” based on its prior year-end balance.
After the year of annuitization, things become clearer. Most experts agree there is no way to use the income from the annuitized annuity in IRA “A” to offset the RMD that must be taken from IRA “B.”
In this situation, the annuity payout will only satisfy the RMD for IRA “A.” Put another way, under the defined benefit plan rules the annuitized IRA now falls under, the annuity payment is the RMD for that IRA account. The RMD for IRA B, with a value of $90,000, will be around $3,800 in this example.
Remember, once an IRA is annuitized, there’s generally no prior year-end balance available from the insurance company for computing an RMD. Thus, a client’s other IRAs only will be used for that calculation. Advisors with clients who are thinking about annuitizing a portion of their IRAs should make this clear before the clients act.
Many, if not most, deferred annuities held in IRAs offer a guarantee. A client is promised a certain amount of cash flow, provided he or she does not withdraw money from the annuity. Often times, the guaranteed income a client can receive increases the longer they “leave the IRA annuity alone.”
Therefore, planning strategies often involve waiting to take distributions from these IRA annuities for as long as possible, even after clients begin taking RMDs. That’s fine, as long as there are other funds within a client’s other IRAs that can be tapped to “make up” for the annuity’s RMD.
Some clients, though, have invested their entire IRA balance in these types of annuities. In order to allow certain benefits to accrue within those accounts, they may want to take the RMD amount from other retirement savings, such as a 401(k) or 403(b) account.
Unfortunately, that’s not permitted. IRA RMDs cannot be aggregated with non-IRA account RMDs. In fact, IRA RMDs can’t even be aggregated with inherited IRA RMDs. An IRA RMD must come from an IRA. Failure to comply with this rule could lead to a 50 percent penalty for failing to take a required minimum distribution. Other penalties could be applied as well.
In this situation, clients might be able to roll over money from their 401(k) or 403(b) to an IRA and then take the IRA RMD. Note: Any RMD due for the 401(k) or 403(b) would have to be taken prior to moving any or all of these funds to an IRA because RMDs are not rollover eligible and are considered the first funds distributed from the company retirement plan.
The rules for RMDs are deceptively complicated and adding annuities into the equation can create additional confusion. But with total U.S. retirement assets at all-time highs and with droves of baby boomers retiring daily, the number of people investing all or a portion of their IRAs into an annuity is likely to continue to grow for the foreseeable future.
That makes your understanding of those complexities and ability to avoid costly traps all the more important.