Mixing Annuities and IRAs

According to the Investment Company Institute, 68% of households with IRAs have mutual funds in those accounts.

That is followed by individual stocks (41%), annuities (35%), and bank deposits (25%). Therefore, annuities are among the most common IRA holdings; they are also among the most controversial because many observers assert that annuities do not belong in an IRA.

Defining the terms

To understand this seeming contradiction, you should know some terminology. Generally, the most heated debate does not involve immediate annuities, which also may be known as income or payout annuities. Here, you give a sum of money to an insurance company in return for a specified flow of cash over a specified time period, perhaps the rest of your life.

Deferred annuities are a different story. With these investments, the money you contribute can grow inside the annuity contract. Different types of deferred annuities offer various ways that the amounts invested can grow over the years. Regardless of the method or the amount of accumulation, earnings inside the annuity are not taxed until money is withdrawn.

Critics of holding deferred annuities inside an IRA say that they are redundant. Any investment inside an IRA is tax deferred or tax-free (with a Roth IRA) so you do not get any tax benefit by investing IRA money in a deferred annuity. Why pay the costs that come with a deferred annuity when you get the same tax deferral with mutual funds, individual securities, or bank accounts held inside your IRA?

Because there might be advantages as well as drawbacks. Deferred annuities offer various guarantees, which might include certain death benefits and certain amounts of cash flow during the investor’s life, regardless of investment performance. Some annuity issuers and sellers contend that these guarantees may be a valid reason to include a deferred annuity in an IRA.

Among different deferred annuities, death benefits and so-called “living benefits” vary widely. Some can be extremely complicated. If you are interested in a deferred annuity, our office can explain the guarantees in the contract so you can make an informed decision.

Verifying value

Another thing to consider when deciding whether to hold a deferred annuity in your IRA is that these annuities must be valued for purposes such as Roth IRA conversions and required minimum distributions (RMDs). This will also arise if you already have such an annuity in your IRA. The reported value of the annuity contract may not be the appropriate number.

Example: Sarah Thomson invests $50,000 of her IRA money in a deferred annuity that offers several investment options. After this outlay, Sarah’s investments decline so her annuity account is now reported at $40,000. Sarah decides this reduced value would generate a lower tax cost on a conversion to a Roth IRA.

However, Sarah’s deferred annuity also contains a rider guaranteeing to pay her a certain amount per year for the rest of her life. Such a rider has some value, which Sarah must include in valuing the annuity inside the IRA if she does a Roth conversion. The same problem will arise when Sarah must take RMDs.

Sarah’s best course of action may be to ask the annuity issuer for help with the valuation because insurers typically have actuaries and software designed to perform these intricate calculations.

ConsultingMichael Malody