Should You Use Your IRA to Buy an Annuity?

For forever and a day, conventional planning wisdom said don’t use your individual retirement account funds to buy an annuity, primarily because traditional annuities featured tax deferral. Recent changes in annuities may alter this conventional wisdom.

Historically, since retirement accounts already come tax-deferred, including an annuity in an IRA essentially meant duplication of effort plus a significant additional cost. Recently, though, the Internal Revenue Service changed its rules regarding IRAs and annuities and likely made mixing the two a potentially smart move.

IRS regulations now allow you to use the lesser of 25 percent or $125,000 of the balance of your IRA – including 401(k)s and other qualified retirement plans – to buy longevity insurance, another term for a deferred annuity. The new rules make it easier for you to balance outliving your assets and unnecessarily limiting your spending in retirement.

With a deferred annuity, you fund the plan over a number of years and begin taking income payments at the end of the specified term, say when you turn age 80. Under the new rules, you can purchase a deferred annuity and eliminate the value of the funds you use to buy the annuity when calculating required minimum distributions (RMDs) from the account.

(You can start RMDs penalty-free from a traditional IRA in the year you turn 70½, when you do pay tax on RMDs at that time. Roth IRAs come with no RMDs.)

One of the primary downsides to annuity ownership: the insurer’s charge to manage the policy, typically 2 percent to 3 percent annually. For this cost, the insurance company guarantees you, the annuitant, a set sum for your lifetime. An annuity typically also ties up your money or at best penalizes you heavily in the first years of the policy with such as surrender expenses of often 8 percent or higher if you withdraw money early.

Nevertheless, let’s say your IRA’s balance is $500,000 as you approach 70½. You can set aside $125,000 in an annuity that begins a guaranteed 10-year payout when you turn 80 and in a decade begin getting a fixed payout of approximately $18,000 annually (a very rough estimate).

Additional policy riders can provide death benefits and guaranteed payouts no matter how long you live, as well as other features to make a given annuity better suit you. Your decision: Is the final benefit worth the extra cost and potential penalties?

Some providers charge much lower annual fees for annuities. If interested in this kind of income guarantee, you can seek out a lower-cost option to keep the drag on your portfolio to a minimum.

In addition, you might look at fixed rather than variable annuities (the latter guarantee no constant amount at payout and can change value depending on then-current market conditions). Fixed annuities are typically lower-cost than the equity-based annuities, pay a fixed interest rate and are generally more conservative.

Annuities have always been a tool – frequently a maligned one – for guaranteeing some kind of income stream. Choose to use this insurance investment based your retirement circumstances and your concern over potentially running out of money during your lifetime.

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Written by Jim Blankenship, CFP, EA. Jim Blankenship is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.

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