And Do You Need One in Your Roth?
- An annuity is a contract between you and an insurance company; in return for investing a lump sum, you’ll receive a stream of payments for several years or even your lifetime.
- A popular vehicle for retirees, annuities can earn tax-free interest at a fixed or a variable rate.
- The tax treatment of your annuity payments depends on whether you bought the annuity with pre- or after-tax funds.
- Buying and holding an annuity within a Roth IRA avoids any taxation of the annuity payouts.
- Buying and holding an annuity within a Roth IRA makes redundant tax advantages of the annuity, but doesn’t alleviate the annuity’s high fees and illiquidity.
Should your Roth IRA include annuities? To understand that question completely, you need to understand both what an annuity is and how its benefits and tax implications mesh with those already afforded by your Roth IRA.
How Annuities Work
An annuity is a contract between you and a financial entity—usually an insurance company. The main purpose of most annuities is to accumulate assets designed to provide you with income in your retirement years.
You buy the annuity, usually with a lump sum. That money is invested and grows. At a designated date, the annuity is converted into payments—or annuitized, in financial lingo. These payments last for a fixed period or, more frequently, for the rest of your life.
In this sense, an annuity is like a fixed-income pension or Social Security benefits.
While in the annuity, the funds grow at tax-free rate; you don’t pay income tax on any interest or earnings they generate.
The Two Types of Annuities
There are two basic types of annuities—immediate and deferred.
Some people purchase an immediate annuity with funds from a retirement account, savings or even lottery winnings. This type of annuity begins making payments soon after it is purchased and those payments can last for several years or for life.
A deferred annuity is purchased (and the funds are invested) over time. When you are ready to begin taking withdrawals, typically in retirement, the process of annuitization takes place. As with an immediate annuity, payments from a deferred annuity can last several years or for life.
Annuity Payments: Fixed or Variable
Both immediate and deferred annuities can dole out their payments at either a fixed or variable rate.
In a fixed annuity, the funds are managed by the financial entity. You have no say in how that money is invested. Once annuitization takes place, a fixed amount is paid to you—either as a lump sum or in payments over several years or your lifetime.
Variable annuities allow you to choose from a menu of investment options. These options could include mutual funds, bond funds or money-market accounts. One version of variable annuity, called an equity-indexed annuity, tracks a specific stock index such as the S&P 500. Obviously, opting for a variable rate holds out the possibility of greater returns; but it also carries greater risk.
Because an annuity is basically an investment instrument inside an insurance policy, fees can be high. You pay fees for the insurance, management fees for the investments, fees if you try to get out of the contract (aka surrender charges) and fees for riders (optional additions to the basic contract, such as one that guarantees a minimum increase in annuity payments each year).
Annuities admittedly can difficult to understand: but one thing is certain Insurance agents and others who sell annuities can make a lot of money from those fees. So, It’s important to carefully review and consider all the costs related to an annuity before you sign on the dotted line.
Taxing Annuity Payments
One key question you’re probably asking about now: Are annuity payouts taxable? That depends largely on whether you purchased the annuity with pre-tax or after-tax funds—terms IRA investors know all too well. Essentially. the taxes you pay on an annuity distribution depend on the portion of that distribution that was not taxed initially (IRS Topic 410 – Pensions and Annuities has the details).
Important: Annuity payouts are taxed as ordinary income, not at the lower capital gains rate.
So, if you purchase the annuity with pre-tax money, such as funds from a Traditional IRA, all payments are fully taxable. If you buy the annuity with after-tax money, you will not pay taxes on the return of your (already taxed) principal, but you will pay taxes on the earnings. (How you figure which is which is a tad complicated, involving something called the exclusion ratio, which divides your withdrawals over your life expectancy. Your accountant can do the math, or the annuity issuer might send you a year-end statement indicating the principal and earnings portions of the payout).
However, if you use funds from your Roth IRA or a Roth 401(k) to purchase an immediate fixed annuity when you retire, all payments will be tax-free because the source of those funds—your Roth IRA—is tax-free. (You’d still house the annuity within the Roth account.) However, the regular Roth distribution rules apply: You must be over age 59½ and you must have had the account for at least five years.
The same applies to investing in a deferred annuity inside your Roth IRA.
Does an Annuity Belong in a Roth?
As noted above, when you purchase an annuity inside a Roth IRA, the IRS rules for the IRA supersede the rules for the annuity. This means that any detrimental tax treatment of the payments is irrelevant if the annuity resides inside a Roth IRA. The advantage of a steady, guaranteed tax-free income stream at retirement, however, might well justify putting a portion of your assets into such an annuity.
That’s from the payment standpoint. But from the investment-growth standpoint, things are a little murkier—especially if you’re relatively young (or at least decades from retirement) and buying a deferred annuity. In this case you would be placing a tax-advantaged instrument (the annuity) inside a tax-sheltered account (the IRA)—which, on its face, doesn’t seem to make a lot of sense.
There’s also the issue of illiquidity. Most annuities carry heavy surrender charges if you decide you want to cash out and invest funds elsewhere. If your annuity is fixed, you have no say in deciding how those funds are invested. If your annuity is variable, the investment options are limited.
And then there’s the fact that annuities are expensive: all those aforementioned fees, which are rather high compared to the annual expense ratios of mutual funds or exchange-trade funds. Also many annuity contracts allow for fee increases by the insurer, something you likely can’t avoid, except at great expense, thanks to those surrender charges.
For some people annuities make sense. For others, they do not. For that reason, investing in an annuity—let alone doing so inside a Roth IRA—should only be done after consulting with a qualified independent financial advisor. There may be other ways to ensure a regular income stream that don’t incur such high fees.