Using Roth IRA funds to buy an annuity
Many people who would benefit from the guaranteed income stream of an annuity lack the cash to make the initial deposit. If you’re in that situation, you may have an alternative: using your Roth IRA to purchase an annuity.
Roth IRAs differ from traditional IRAs and 401(k)s in their tax treatment. The latter two vehicles allow pre-tax contributions and tax-deferred growth, but owners will pay income taxes on the income they withdraw. Roth IRAs, on the other hand, do not allow pre-tax contributions but both the earnings growth and income distributions are tax-free as long as you meet minimum requirements.
Roth IRAs allow you to withdraw funds equal to what you contributed to the account at any time; you do not have to be age 59 ½. But you do have to be at least that old and have held onto the account for five years or more before you can withdraw any of the earnings on the account.
So for example, if you contributed $50,000 to your Roth IRA and it’s currently valued at $100,000, you could withdraw $50,000 at any time. But you would have to wait until age 59 ½ and have owned it for five years before you could take out the full $100,000.
This is important to understand if you plan to purchase an annuity with Roth funds. The tax-free treatment of payments made from a Roth account only applies to qualified distributions, which are those made after age 59 ½. If a distribution doesn’t qualify, then any untaxed growth becomes taxable income and might be subject to an additional 10 percent penalty tax. Therefore, even though Roth allows principal to be withdrawn before age 59 ½, you will need to wait until then to transfer those funds into an annuity if you want the full tax benefit.
And as long as you meet the holding and age requirements for a Roth IRA, the payments from an annuity bought with Roth funds will be tax free. So if you have the option of buying an annuity with Roth funds, 401(k) funds or cash, from a tax standpoint the best option would be using the Roth account.
The benefit of using a Roth for an annuity
The decision of whether to convert your Roth IRA into an annuity can largely be made based on which of these two benefits is more important:
A guaranteed stream of lifetime income
The ability to pass on your assets to your heirs tax-free
The argument for converting a Roth IRA into an annuity is the peace of mind of having a guaranteed income stream and not having your retirement funds exposed to the whims of the stock market.
Market downturns do double the damage during retirement when you’re withdrawing income. Not only are you depleting your assets by spending them on retirement needs, but you’re also losing money from the market itself.
Even if you reallocate your IRA assets to very conservative investments during retirement, the small rate of return will not be able to keep up with the amount of withdrawals. Eventually, your account will run out of money.
This isn’t an issue with a fixed annuity because the income is guaranteed for whatever period of time you choose, be it five years, 10 years or for life. You will never have to worry about how poorly the market is performing and its effect on your retirement account.
The downsides of this conversion
The main downside of this kind of transaction is how it will impact your beneficiaries. Roth IRA beneficiaries do not pay income tax on distributions from the Roth account. Annuities that pay lifetime income streams often do not transfer any funds to beneficiaries; once you pass away, the insurance company issuing the annuity stops payments. Some insurers include optional riders or have death benefit features; however, if your heirs receive a payout from your annuity, they will have to pay tax on any growth above your remaining tax basis.
Another downside is losing control of your retirement funds. Once you pay the insurance company your premium for the annuity, that money is more or less unavailable for other uses. If you buy an immediate annuity, you’re mostly locked in to the amount and length of income payments you agreed to in the contract. If you purchase a deferred annuity, you are required to keep the funds at least as long as the surrender period, which could be three to 15 years. Otherwise you will be assessed a penalty for early withdrawal by the insurance company.