Annuities inside qualified retirement plans
An investment options you may have for your 401(k), IRA, or other qualified retirement plan is an annuity. Plans may offer immediate and deferred annuities, as well as fixed, indexed and variable contracts.
Some advisors believe you should never purchase an annuity inside of a qualified retirement plan. The reason: since annuities offer tax-deferred growth on their own, there’s no need to use 401(k) or IRA assets to buy one. After all, there’s no way to earn double the tax benefits.
This position ignores the fact that there are many more reasons to purchase annuities beyond tax deferral. The same benefits annuities provide outside a qualified plan — the potential for guaranteed lifetime income being the main one — are still applicable if your annuity is inside a 401(k) or IRA.
Differences in tax treatments
One potential advantage of purchasing an annuity inside a qualified plan is doing so with pre-tax money. If you purchase an annuity outside a qualified plan, you receive no tax deduction on that contribution. Contributions to a qualified plan, from you which you could buy an annuity, are tax deductible.
Keep in mind that the income from the annuity will also be taxed differently whether inside or outside a qualified plan. For annuity distributions outside a qualified plan you will not pay tax on the portion of your payments that is considered a return of your original premium. The taxable portion is what your annuity pays above and beyond what you put into it. For example, if the value of your annuity doubles what you deposited, then half of your income withdrawals will be taxed as regular income. The other half will be considered a return of your principal.
Annuity income deriving from a 401(k) or IRA will be taxed in full as regular income as with any distribution from a qualified plan.
You also have the option of placing an annuity inside a Roth IRA. While you won’t receive a tax-benefit for the contribution to the IRA, your annuity income would be tax-free because of the tax treatment of Roth plans.
Disadvantages of using qualified funds for annuities
Keep in mind that the same disadvantages that exist with non-qualified annuities will impact your decision to use qualified plan assets. The biggest disadvantage is losing control of those assets. Once you have committed premium to the annuity contract, it’s essentially unavailable for the duration of the contract, with a few exceptions.
If you purchase an immediate annuity, you lose access to the full amount of what you paid into the contract. You will receive the income payments for as long as you established in the contract, but you cannot get back your original capital.
Deferred annuities have a surrender period during which you have to leave most or all of the money in the annuity for that set period of time before you can take withdrawals. If the owner of an annuity insists on pulling money out before the end of the surrender period, the insurance company will assess a penalty known as a surrender charge.
Having an annuity inside a traditional IRA can also pose tax issues if you decide to convert it to a Roth IRA. The conversion rules become complicated when an annuity is involved, specifically regarding the contract’s fair market value. If you have this situation, you will want to consult a tax professional.
Dealing with RMDs
Qualified retirements plans and annuities that grow tax deferred are subject to Required Minimum Distributions (RMDs). To prevent account holders from earning tax deferral for as long as they wish, the IRS requires minimum distributions starting no later than when the account owner reaches age 70 1/2. The distribution amount is based on the account’s year-end value and a formula calculated by the IRS.
A potential strategy to offset RMDs is using a deferred annuity with a contractual death benefit rider. This is often used for people who want to preserve as much of their retirement assets to pass on to beneficiaries. This type of contract can be structured so that the death benefit rider value grows at the same percentage as your RMD. Therefore, you could take RMDs as long as you live and not decrease the principal within the account.
When you purchase an annuity inside a qualified plan, you need to make sure your RMD doesn’t lead to a surrender charge. This doesn’t happen often, but it is a another possible pitfall to avoid. Basically it occurs when the annuity contract’s provisions and IRS requirements compete against each other.
Where you could run into problems is if, at say age 65, you use all or most of your qualified plan assets to buy a 10-year annuity. Because the annuity has a 10-year surrender period, the insurance company will assess a withdrawal charge if you take out more than the free withdrawal amount before you turn 75. However, the IRS will dictate you withdraw a minimum amount starting at age 70 1/2, or else it will assess a penalty.
It’s easy to avoid this situation; just make sure that by the time you have to withdraw money from the qualified plan that there won’t be surrender charges to pay.