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.
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.
When the annuity is converted into payments (annuitized), the payments last for a fixed period or, more frequently, for the rest of your life. In that sense an annuity is like a fixed-income pension or Social Security benefits.
The Two Types
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 funds 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.
Fixed or Variable
Both immediate and deferred annuities can be either fixed or variable.
Funds in a fixed annuity 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.
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 guarantees such as one that guarantees a minimum increase in annuity payments each year).
Insurance agents and others who sell annuities can make a lot of money from those fees. That alone is reason to be cautious before purchasing an annuity. Since annuities are difficult to understand, it’s also wise to carefully consider and understand all fees related to an annuity before you sign on the dotted line.
Tax Treatment of Annuities and Roth IRAs
Tax treatment of annuity payments depends on whether you purchased the annuity with pre-tax or after-tax money. If you bought 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.
If you purchase the annuity with pre-tax money, such as funds from a Traditional IRA, all payments are fully taxable. Essentially the taxes you pay on an annuity distribution depend on the portion of that distribution that was not taxed initially. For more information see: IRS Topic 410 – Pensions and Annuities.
If you use funds from your Roth IRA [or 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.
The same applies to investing in a deferred annuity inside your Roth IRA. In this case you would be placing a tax-deferred annuity inside a tax-sheltered IRA—which, on its face, doesn’t seem to make a lot of sense. The advantage of a steady, guaranteed tax-free income stream at retirement, however, might justify putting a portion of your assets into such an annuity.
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 tax treatment that applies to an annuity that might be beneficial to you is irrelevant if the annuity resides inside a Roth IRA.
There’s also the issue of surrender charges if you decide you want to invest annuity funds elsewhere. If your annuity is fixed, you have no say in deciding how those funds are invested. Finally, many annuity contracts allow for fee increases by the insurer, something you likely can’t avoid, except at great expense, thanks to those aforementioned surrender charges.
Does an Annuity Belong in a Roth?
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.
And because of those high annuity fees, you should study the fee structure carefully before signing any contract. Make sure the advantages to you justify the fees you will likely face.