IRA Annuity Surprises
And not the good kind, either, says contributor Natalie Choate.
When an IRA is converted to or invested in an annuity, the required minimum distribution results can create some unwelcome surprises, as these examples illustrate.
Please note: These examples are entirely hypothetical and are not intended to endorse the planning ideas discussed. Moreover, this column concerns “true” (“immediate”) annuities providing guaranteed regular payments from an insurance company in exchange for a lump sum investment, not “deferred” annuities being held as an investment asset.
Bonnie, age 71, has $1 million in her Traditional IRA. With her advisor, she determines this is not enough to finance her retirement in the desired style for her desired life span. Although the solution seems to be to invest more aggressively, she wants an assured income for the next 10 years to allow for a longer time horizon for the aggressive investment program. So she purchases, inside the IRA, an annuity that will pay her $60,000 a year for the next 10 years. This costs her $550,000, leaving $450,000 for the ambitious investment program. She and her advisor assume that the $60,000 of annual annuity payments will be more than enough to cover the required minimum distributions for Bonnie’s IRA, so that (1) the $450,000 can be fully invested for the entire 10-year term, and (2) Bonnie’s taxable income will be a predictable $60,000 a year.
Their plan will work for the year the annuity is purchased--for that year only, the payments Bonnie receives from the annuity will count toward her RMD for the entire combined IRA value. Unfortunately for Bonnie, however, that will not be true for the second and all subsequent years. The RMD rules for annuities don’t work that way.
When money from an IRA is converted to an immediate annuity, that money “steps out” of the traditional familiar minimum distribution rules starting the year after the purchase. As explained in a previous column, annuity contracts get their own set of RMD rules. Under those rules, beginning the year after the contract is purchased in the IRA, the contract is no longer considered part of the “account balance” of the IRA for purposes of determining the RMD from that IRA.
Instead, the payments under the annuity contract become the RMD with respect to the annuity portion of the contract. Meanwhile, the rest of the account must continue to pay its own separate annual RMD, computed in the usual way--account balance divided by applicable life expectancy factor. So Bonnie’s taxable income from her IRA each year will be the $60,000 annuity payment plus the RMD from the nonannuity portion of the account. As a result, the investment program for the nonannuitized portion of the account will have to take into consideration the need to pay out its own annual required distribution to Bonnie.
Herbert, age 72, has a $500,000 IRA. For some legal reason, he is facing a need to minimize the value of his “assets,” and converting assets to an income stream will solve his problem. (I am told this scenario can arise when someone is facing a need to qualify for certain government benefits or in connection with a divorce, lawsuit, or college financial aid application, and so on. I don’t know if the strategy “works”--I’ve just been told that people do this.) With his lawyer, he decides to invest the IRA in an immediate five-year annuity. Then, apparently, the IRA asset “disappears” and the annuity payment will be considered income. Herbert and his advisor then assume that, once the crisis is past, he can just roll the payments he receives from his IRA annuity back into a regular IRA account to continue deferring taxation.
Unfortunately for Herbert, he will not be able to roll those annuity payments back into an IRA. Once a permitted annuity contract has been purchased in an IRA, all distributions under that contract are considered RMDs, and, as such, they are not eligible rollover distributions.
Wait a minute, says Herbert--I could have purchased a life annuity instead of a five-year fixed-term annuity, and then my payments under the contract would have been much smaller. Why can’t I roll over the difference between the smallest payout I could have opted for and the larger payment I actually purchased?
Because, Herbert, the regulations say: “If the annuity contract ... under which distributions to the payee are being made is a permissible annuity distribution option, the required minimum distribution for a given calendar year will equal the amount which the annuity contract ... provides is to be distributed for that calendar year.”
Where to read more: Treas. Reg. Section 54.4974-2, A-4(a).
Natalie Choate is an estate planning lawyer in Boston with Nutter McClennen & Fish LLP. Her practice is limited to consulting regarding retirement benefits. The new 2019 edition of her best-selling book, Life and Death Planning for Retirement Benefits, is now available through her website: www.ataxplan.com, where you can also see Natalie’s speaking schedule and submit questions for this column. The views expressed in this article may or may not reflect the views of Morningstar.