Should Annuities Be in IRAs?

It is past time to consign to the dustbin of financial history another long-time financial rule of thumb. I hear it regularly when making presentations. People say, “I thought it never was a good idea to buy an annuity in an IRA.” That used to be reasonable advice but no longer is in many cases.

Years ago annuities were purchased primarily for the tax deferral they provided. There were only a few types of annuities and they paid bond-like interest. They didn’t offer much more, and the main reason to buy an annuity was to be able to defer taxes on the interest. There was an expectation that people would be in a lower tax bracket after retirement. Often, people were in substantially lower tax brackets in retirement than during their working years. So, they’d have more after-tax purchasing power if taxes on the interest could be delayed until retirement. Since both annuities and IRAs provided tax-deferral, it didn’t make a lot of sense to purchase an annuity in an IRA.

Annuities have changed. There are many different types of annuities and reasons for buying them. While they still provide tax deferral, it often is not the main reason for purchasing an annuity.

variable annuities now often offer some kind of guaranteed lifetime withdrawal or income benefits. In fact, about 80% of variable annuities sold in recent years contained such riders. Fixed deferred annuities are a portfolio diversifier with some advantages over bonds and certificates of deposit. Fixed indexed annuities offer safety of principal plus the potential for higher income than FDAs. Longevity and immediate annuities are purchased to guarantee income for life, no matter how long that life may be. Some annuities also offer riders to pay for long-term care expenses.

In other words, most annuities now are purchased to provide a benefit other than tax deferral. Guarantees and risk transfer are the major reasons people buy annuities these days. Tax deferral often is a side benefit.

Some variable annuities still are purchased for their tax deferral. After deferrals to a 401(k) and contributions to an IRA are exhausted, further tax deferral of investment income and gains might be desired. This is especially true for higher-income people after the addition of the new net investment income tax of 3.8%. A Variable Annuity also is a way to defer taxes on some tax inefficient assets or strategies.

Another reason to consider buying an annuity through an IRA is the bulk of liquid investment assets many people own are in IRAs. When someone wants the guarantees, risk transfer, and other benefits offered by an annuity, the only way to obtain it is to purchase the annuity through an IRA. The alternative is to take a distribution from the IRA, pay the taxes, and deposit only the after-tax amount in the annuity. There’s no reason to do that.

Also, IRA balances have soared. Years ago, putting an annuity in an IRA often meant taking the scarce benefit of tax deferral from investments that could use it. Now, IRAs are likely to have plenty of room for both annuities and other investments. Other assets aren’t being deprived of tax deferral when an annuity is included with them in an IRA.

There are no direct penalties for owning most annuities inside an IRA and usually no fees beyond what you’d incur from purchasing the annuity outside an IRA.

One potential disadvantage of an annuity in an IRA is required minimum distributions after age 70½. Annuities owned outside of an IRA don’t have RMDs. You can allow the income and gains to compound as long as you want, even passing them on to a beneficiary after you pass away. But once an annuity is in an IRA, the RMD rules apply. The insurer computes the RMDs following IRS regulations and tells you how much must be distributed each year after age 70½. An exception is for qualified longevity annuity contracts (QLACS). When held in an IRA they allow RMDs on that portion of the IRA to be deferred until as late as age 85.

Annuities offer a range of benefits other than tax deferral, and those other benefits are the driving reason for most annuity purchases. It’s time to discard this old rule of thumb. Purchasing most annuities through IRAs can be a solid strategy and can increase your financial security.