Some of the most confusing IRA annuity RMD issues arise when a client annuitizes an IRA annuity contract. Some of that confusion stems from the fact that the IRS offers little guidance in some of these areas and thus a lot is left up to interpretation.
When annuitizing, a client makes an irrevocable election to receive a guaranteed income stream over a number of years, a lifetime, or a joint lifetime. With regard to annuitized IRA annuities, there are two possibilities. Either the IRA annuity contract is annuitized so that:
Payments will continue for no less than the lifetime of the IRA owner (or possibly over a joint life expectancy); OR
Payments will be made over a specific number of years only (i.e., 5 years, 10 years, 20 years, etc.)
RMDs after lifetime (joint lifetime) annuitization
Although there are still vagaries with regard to certain issues, most experts agree that rules for annuitizing an IRA annuity over an IRA owner’s lifetime or over the joint lifetime of the IRA owner and another person are straightforward. In such cases, an annuitized IRA generally transitions from following the rules for defined contribution plans to following the rules for defined benefit plans, like pensions.
When a client has a pension and receives a monthly benefit, you don’t generally think about calculating the required minimum distribution for the pension, or about using distributions from the pension to offset required minimum distributions for other retirement accounts. That’s because whatever distribution your client is receiving from a pension is the RMD for the pension — no higher, no lower.
The same is true for an IRA annuity that has been annuitized over a lifetime or joint lifetime. Once that annuitization has occurred, distributions produced by the contract are the RMDs for the contract. Thus, no shortfall or excess RMD taken can be used to offset the required minimum distribution for other IRAs (other than a possible exception in the year the annuitization takes place, as discussed below). Example:
Ron has only one IRA, with a $100,000 balance, which he annuitizes over his life expectancy. What’s his RMD? Here, the answer is simple. The annuitized payment that is distributed from 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, for 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 balance. 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 murky.
There is some debate over whether or not such a distribution from an annuitized 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 rules instead of the defined contribution rules. That would lead you to believe the answer is no.
On the other hand, RMDs are based on 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 (which is the view supported by most — but not all — experts in the field). In light of the grayness in this area, the most 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 get much clearer. Nearly all experts agree there is no way to use the income from the annuitized annuity in IRA A to offset any of 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 total 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.
RMDs after period certain (only) annuitization
The wheels start to come off the cart once IRA annuities are annuitized over a specific period of years and not over a lifetime or joint lifetime. In such cases, expert interpretation is all over the place. Many interpret the rules to be the same for period certain-only annuitization as they do for annuitizations made over a life expectancy or joint life expectancy when an IRA owner is over age 70.
In other words, though a contract may only be annuitized over five years, what would be distributed out of the annuity is still interpreted to be the required minimum distribution. Example:
Recall Ron from our previous example, who had $90,000 in one of his IRAs and $100,000 in the other, which he annuitized over his life expectancy, producing a $9,000 yearly payment.
Suppose that instead of annuitizing the $100,000 IRA over his life expectancy, Ron annuitized it over a five-year period. Now, instead of a $9,000 payment each year, Ron has a payment of $22,000.
Many experts believe that though the $22,000 payment accelerates distributions from his retirement account at a faster pace than would ordinarily be required, it is still the RMD for that contract. Thus, Ron would have to pay tax on that amount each year, plus the amount he distributed from his other IRA to satisfy the RMD for that account.
To reiterate, this is one area of the law that is extremely gray and subject to interpretation, and some experts subscribe to still other views not presented here. In these situations, you may wish to consult with your own back office resources to see how they interpret the rules, or with your client’s tax advisor and document those discussions.
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