05 Jul Annuity inside an IRA? Consider this
Q. My father wants to buy an annuity inside an IRA. I say that’s a waste of the tax benefits. What do you think?
A. Conventional wisdom says that you shouldn’t own an annuity within an IRA.
The account’s tax-deferred status makes owning the annuity like wearing a raincoat indoors — it just isn’t necessary, said Michael Green, a certified financial planner with Wechter Feldman Wealth Management in Parsippany.
But the real answer, he said, depends on which type of annuity you are holding in the IRA.
Annuities, if used correctly, can help lower your Required Minimum Distribution (RMD). More on that in a moment.
First, the basics.
Annuities are contracts between individuals and insurance companies that can provide the purchaser with a steady stream of income during retirement, Green said.
“They can — and often do — play a role in replacing or supplementing fixed income streams for older individuals who are already receiving pensions and/or Social Security, and annuities are known for their tax efficiency,” he said.
Annuities grow tax-deferred, which means that you only pay income tax when funds are withdrawn from the annuity account, he said. This allows for compounding interest and potentially higher overall earnings because as the annuity earns interest, the growth is not taxed immediately.
Annuities come in many shapes and forms, but there are two main types of annuities: fixed and variable, he said.
“Many retirees choose fixed annuities for their predictability, stability and guaranteed stream of income,” Green said. “With a fixed annuity, the life insurance company agrees to pay a fixed rate of income to the investor for life.”
Generally speaking, fixed annuities involve less investment risk than variable annuities because of their guarantees, and the minimum rate is not affected by fluctuations in market interest rates, Green said.
However, depending on the current rate environment, you may incur the risk of locking in a fixed current rate and then interest rates going up.
Then there are variable annuities, which give investors the opportunity to earn higher rates of return by investing in equity and bond sub-accounts. These may increase the amount of growth in their account and provide a higher income stream to potentially outpace inflation over time, Green said.
“The downside risk is that the sub-accounts may not outperform a fixed annuity’s guaranteed return, which can result in less growth over time and a smaller income stream,” he said.
The Required Minimum Distribution (RMD) calculation for an annuity depends on whether or not it has been “annuitized,” meaning it is turned into a stream of payments over a period of time – usually the owner’s life expectancy.
“It is important to note that once you make the decision to annuitize, it cannot be reversed,” Green said. “You must be aware that you are foregoing any future withdrawals from the annuity and must be paid out of the stream of income throughout your lifetime.”
If your IRA holds an immediate annuity – an annuity that begins making payments immediately after purchase – you may or may not need to include its value when calculating your RMD for that year.
For example, Green said, if you have $300,000 in an IRA and use $100,000 to buy an immediate annuity, the $100,000 is turned into a stream of payments and would be excluded from the RMD calculation.
However, if the annuity is going to be owned in your IRA but not annuitized, then its value must be included along with non-annuity holdings when calculating the RMD, he said. Once you annuitize, you do not include the payments in your RMD calculation.
So if you’re looking for a way to lower your RMDs, this could be one strategy to consider.
Email your questions to moc.p1571225450leHye1571225450noMJN1571225450@ksA1571225450.