While many advisors have counseled against purchasing an annuity with IRA funds in the past, in today’s post-recession world, there are a variety of valid reasons why a client may be interested in the annuity-within-an-IRA strategy. However, as with any retirement income planning strategy, the pitfalls associated with a poorly executed annuity purchase strategy can cause unnecessary expenses and disappointment down the road.
This is especially true if the client is planning to use the annuity as a tool for simplifying his or her IRA required minimum distribution (RMD) obligations. Because a separate set of rules governs each individual type of annuity that may be held within an IRA for RMD purposes, it is important that the advisor carefully examine the proposed annuity purchase in light of the client’s goals in order to ensure not only that the RMD rules are followed, but also that those goals are furthered.
The annuity impact on RMD rules
In general, a client may hold either an immediate or deferred annuity within his or her IRA. An immediate annuity allows the client to begin receiving annuity payments immediately (or very shortly after the contract is purchased). Once annuitized, the value of these types of annuities are excluded from the value of the IRA for purposes of calculating the RMDs for the non-annuity IRA assets.
Importantly, the client should be advised that he or she will be required to calculate RMDs on those non-annuity assets held within the IRA even though he or she is receiving annuity payments. It is also important to note that immediate annuities purchased within an IRA must provide that payments will begin no later than when the client reaches 70 ½, and the minimum guarantee term generally must end around the time the client reaches age 96.
On the other hand, the fair market value of a non-annuitized deferred annuity that is held within an IRA is included in the value of the account (as of the end of the prior year) in computing RMDs for the year.
Fair market value can be difficult to discern in some cases because it must take into consideration both the purchase price and, in some cases, applicable minimum guarantees. Additional benefits offered through riders can also add value, and calculating the value of these benefits can become complicated. In general, it is advisable that clients obtain a calculation of the fair market value of a deferred annuity from the insurance company that sold the contract.
Qualified longevity annuity contracts (QLACs) are deferred annuities that satisfy specific IRA-mandated criteria, and are subject to an entirely different set of rules than traditional deferred annuities. Within statutorily prescribed limits, the value of these annuities is excluded from the IRA account value in determining RMDs in order to encourage the purchase of deferred annuities within retirement accounts.
Why purchase an IRA annuity?
Immediate annuities that are held within an IRA can help to simplify the client’s financial life because they usually comply with the RMD rules automatically — payments are determined in the same way that the RMD itself is calculated, using a formula based on the life expectancy of the client and the amount invested.
Further, the income generated from the annuity can help maximize the investment performance of other IRA assets. While a cash RMD is required each year after the client turns 70½ regardless of general market conditions, it is important to remember that IRA assets may be invested in a variety of holdings, including securities and funds that will fluctuate with the equity markets.
Unfortunately, the RMD requirements may, depending on market performance, cause clients to miss out on market upswings by requiring the liquidation of appreciating IRA assets in order to satisfy RMDs (the same problem arises when the client needs funds in excess of the RMD to cover basic living costs). Using a fixed income annuity can help minimize this risk because the payments are fixed in advance.
Importantly, annuities held within IRAs continue to offer many of the income guarantee benefits that client look for in annuities generally — providing a level of stability to the IRA performance which can be especially important if the bulk of the client’s retirement assets are contained within the IRA, so that he or she may not have the option of purchasing an annuity with non-IRA funds.
Annuitizing a portion of a client’s IRA can help simplify that client’s retirement income planning to a certain extent — but it also presents its own set of complications that must be understood in order to properly execute such a strategy.
This article was drawn from 2016 Tax Facts on Individuals & Small Business, and originally published by The National Underwriter Company, a Division of ALM Media, LLC, as well as a sister division of LifeHealthPro. As a professional courtesy to LifeHealthPro readers, National Underwriter is offering this resource at a 10 percent discount (automatically applied at checkout). Go there now.
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