Answers to Key Issues About IRAs or 401(k)s and Annuities

Combining annuities with IRAs or 401(k)s can be powerful. But often people don’t even consider the combination because of widespread misinformation and confusion.

Many people want the principal protection or guaranteed lifetime income available from annuities. When most of their investable assets are in IRAs or 401(k)s, questions about how those accounts interact with annuities keep them from moving forward.

Some people say that an IRA isn’t allowed to hold an annuity.

That’s not true. The tax code allows most types of annuities to be held in both traditional IRAs and Roth IRAs.

Annuities also can be held in 401(k) s. In the SECURE Act, enacted in 2019, and the SECURE Act 2.0, enacted in 2022, Congress changed the rules to make it easier for employers to offer annuities in 401(k)s and encourage them to do so.

But employers aren’t required to allow their 401(k)s to hold annuities, and many 401(k)s still aren’t set up to allow annuities.

Some people say that though an IRA is allowed to own an annuity, it isn’t a good idea.

Their argument usually is that an annuity already has tax deferral so there’s no point in adding an annuity to an IRA that also has tax deferral. You don’t receive a double tax benefit from owning the annuity in an IRA.

But there are many reasons to own an annuity, and tax deferral is a relatively minor one. Consider these scenarios.

During the accumulation years, you might want some of your capital in a multi-year guaranteed annuity (MYGA) or an indexed annuity to earn interest in a way that protects your principal. The annuities might be more attractive to you than certificates of deposit (CDs) or other vehicles that earn interest and protect principal.

If the money you need to buy the annuity is in an IRA, there’s no reason not to hold the annuity through the IRA.

When a MYGA is owned by a Roth IRA, the interest earned eventually will be tax free when distributed to you or your beneficiary.

But it usually is best to have growth-oriented investments held through a Roth IRA. The tax-free status of the Roth IRA is very valuable, and it generally is best to have your highest-returning investments in the tax-free shelter. Even so, when the annuity is the best choice for you and most of your available money is in the Roth IRA, the annuity can be purchased through the Roth IRA.

In another scenario, during retirement you might want a portion of your retirement savings in an annuity that pays guaranteed lifetime income, such as a single premium immediate annuity (SPIA) or deferred income annuity (DIA). Again, if the money you need to buy the annuity is in an IRA, there’s no reason not to own the annuity through the IRA.

Whether a retirement account or other account is the best way to own an annuity depends on how your assets are distributed among different types of accounts. If an annuity is appropriate for you and the money you need to buy it is in an IRA, there’s no tax or other reason not to have the IRA buy the annuity.

The mechanics of owning an annuity of any type through a retirement account are very simple.

After you enter into the annuity contract, the insurer will create an IRA in your name. Then, you have the money rolled over from your existing IRA or 401(k) to the annuity IRA. The rollover is nontaxable.

The annuity IRA purchases the annuity.

When the annuity is a SPIA or DIA, the IRA will receive regular income payments from the annuity and distribute them to you. You’ll include the payments in gross income to be taxed, in most cases.

When an annuity IRA owns a MYGA or indexed annuity, you eventually can roll the money back to the original IRA or another IRA, to the extent the annuity contract allows. That also will be a tax-free rollover.

The tax code allows an annuity that pays guaranteed lifetime income (such as a SPIA) to be purchased through a 401(k) and, to some extent, encourages employers to offer that option.

But many 401(k)s don’t offer a SPIA option or the option might not pay as much income as other annuities on the market.

An option in those cases is to make a tax-free rollover from the 401(k) to a traditional IRA. Then, you enter into an annuity contract, the insurer sets up an annuity IRA, and you make a tax-free rollover from the traditional IRA to the annuity IRA.

Required minimum distributions (RMDs) are another confusing issue when annuities are in retirement accounts, but it really is a simple issue.

The mandate to take RMDs still applies when an IRA or 401(k) owns an annuity. (Remember, the original owner of a Roth IRA isn’t subject to RMDs.) The type of annuity owned by an IRA determines how the RMD rules apply.

When the retirement account owns an accumulation annuity such as a MYGA, indexed annuity, or even a variable annuity, the balance in the annuity account is included in the value of the IRA to compute the RMD.

But you might not have to take money out of the annuity to pay the RMD.

For example, to compute an RMD for 2024, you first would determine the balance of each of your traditional IRAs on December 31, 2023. The value of each IRA is divided by the factor for your age from the appropriate life expectancy table in IRS Publication 590-B.

When you own multiple traditional IRAs, you have options after computing the RMD for each IRA.

You can take each IRA’s RMD from that IRA. Or you can total the RMDs and take them from the IRAs in any proportion you want. You can take the aggregate RMD from one IRA if you want as long as you have enough IRA assets outside the annuity.

This option is helpful when you don’t want to take money out of an accumulation annuity yet. You can leave the annuity untouched and take the RMD from other IRA assets.

It’s a different story when there’s a SPIA or DIA in an IRA paying you lifetime guaranteed income.

The annuity income payments satisfy the RMD for that part of your IRA assets. The insurer makes sure when creating the annuity that the income payments will at least satisfy the RMD rules.

For the rest of your traditional IRA assets, you follow the procedure described above. Compute the RMD for each IRA and take the aggregate RMD from the IRAs in any ratio you want.

Of course, you can defer some of your traditional IRA RMDs by purchasing a qualified longevity annuity contract (QLAC).

The QLAC will pay you a fixed amount of income each year for life. You select the date the payments begin. They can’t begin any earlier than two years after the QLAC was acquired and must begin by age 85.

The money in the QLAC isn’t included in the IRA value when computing RMDs in the years before the QLAC begins paying income. Once the QLAC begins paying income, the distributions satisfy the RMD for that part of your IRA holdings. For more details about QLACs, see the August 2023 issue of RW.

Of course, you shouldn’t buy an annuity through an IRA or 401(k) simply because you can. Consider the reasons for buying a specific type of annuity.

When you want additional guaranteed lifetime income to supplement Social Security and any pension you have, consider a SPIA or DIA. Or if you want to earn interest while protecting the value of your principal, look into MYGAs or indexed annuities.

When an annuity is appropriate for your goals and the money you need to acquire it is in an IRA or 401(k), then buy the annuity through the retirement account.

As always, when considering an annuity, don’t buy when a financial advisor is offering only one product. First, determine if a certain type of annuity will meet your goals. Then shop the market for the best annuity of that type.

Work with a consumer-friendly insurance expert. I recommend Todd Phillips and Stan Haithcock.

You can reach Todd at Phillips Financial Services at 888-892-1102 or visit https://epmez.com.

Stan also is known as Stan the Annuity Man. Review his annuity calculators and other materials at www.stantheannuityman.com. Then, book a call with him.