I’ve consulted many clients over the years who used their IRA funds to buy an annuity investment. The most common questions I get are as follows.
- What is an annuity? Now mind you, these are persons who already own an annuity.
- Can I cancel it and get my money back to invest in something else, and is there a penalty?
Most of our clients who own an annuity with an IRA are seeking to use those retirement plan dollars in a new investment opportunity with the goal of increasing returns. However, “getting rid” of an annuity owned by your IRA isn’t as easy as selling a mutual fund or stock investment.
WHAT IS AN ANNUITY?
An annuity is a contract with an insurance company whereby the person invests a lump-sum (or a series of payments) with an insurance company and the insurance company agrees to pay certain sums to the owner over their life. There are many variations of annuities but the simple explanation is that you give up money now to an insurance company and they promise to pay you money later. The longer you wait to get paid the more they will pay you later on.
CAN I CANCEL MY ANNUITY?
You can cancel an annuity but you may be subject to a surrender penalty. Most annuities have a surrender penalty whereby the owner of the annuity is penalized for requesting a return of the investment within a certain period of years of the initial investment. This time period is known as the surrender period and on average will last from 5 to 10 years. The surrender penalty on a 10 year surrender time period is usually 10% and decreases by 1% each year thereafter until it goes to zero after 10 years.
So, if you invested a lump-sum of $100,000 into an annuity and one-year later (in years 2) you wanted to get the entire $100,000 back out, you would be subject to a 9% surrender penalty of $9,000. That would mean you could get back $91,000 but would forfeit the remainder. Some penalty schedules are more punitive and they all vary. The surrender schedule is in the annuity contract documents and can also be requested at any time from the company holding the annuity.
KEEP IT IN AN IRA TO AVOID TAXES
Once you cancel an annuity owned by your IRA, the funds need to stay within an IRA (e.g. self-directed IRA) in order to avoid taxes and penalties from the IRS. You can request the annuity company to transfer the IRA annuity cash balance over to a new IRA custodian of your choosing. Once you’ve taken these steps, you’re retirement plan funds will be in an IRA and available to invest in stock, bonds, mutual funds, real estate, private companies, precious metals, and all other investments available to IRAs.
IRAs are the most commonly held retirement account and annuities are one of the most popular investments for retirees. Despite the popularity of each, the two concepts shouldn’t ordinarily be combined together. On the topic of IRAs and annuities, I am routinely asked the following questions.
- Can I buy an annuity with my IRA?
- Should I buy an annuity with my IRA?
- How do I get out of an annuity I bought with my IRA?
- Can I roll-over my annuity IRA to a self-directed IRA?
In this article I’ll answer each question, but before I do, let me first explain how an annuity works as it is essential to understanding the questions and your options. IRS Publication 939 is helpful in explaining the annuity tax rules and can be found here.
An annuity is an insurance product you can purchase whereby you invest funds with the annuity insurance company and they agree to make payments to you for the rest of your life or for a set period of years. The typical candidates of annuities are retirees seeking a guaranteed steady stream of income. The retiree gives up their cash now in exchange for payments back from the insurance company over time. There are many different types of annuities but the two most common are fixed annuities and variable annuities. In a fixed annuity, the insurance company agrees to pay you back based on a fixed payment schedule. Under a variable annuity, the insurance company agrees to pay you back based on the performance of the annuity investment (you have some limited choices in how those funds are invested in a variable annuity).
An annuity can begin paying you back immediately or it can be invested over a period of time and grow tax deferred and then later pay you out at retirement age. The income from an annuity is taxed as it is received by the annuity owner. Typically, when you receive payments from an annuity you personally own (outside a retirement account), a portion of the payment is taxable (the income/growth part) and the portion that is a return of your investment or premium is not taxable. The portion of the annuity payment that is taxable is subject to ordinary income tax rates.
One of the benefits of an annuity is that the funds grow in the annuity tax deferred with the funds compounding and without having to pay tax on any income the IRS. When you start receiving payments from the annuity, the funds you invested into the annuity are not taxed but the earnings are taxed.
No Contribution Limits
When you purchase an annuity outside of a retirement account such as an IRA, you can invest as much money as you want and you are not limited to annual contribution limits like you are with IRAs or 401(k)s. So, for example, if you want to buy a $250,000 annuity with $250,000 of cash, then you can make that investment all in one-year. You are not subject to $5,500 annual contribution limits.
If you take funds from an annuity before you’re 59 ½, you’re subject to a 10% early withdrawal penalty on any taxable earnings. Any investment gains (above your initial investment) are also subject to tax and must be included as regular income on your personal tax return.
When you own an annuity you will typically have an account value for that annuity and if you decide to “cash-out” the annuity, instead of receiving the scheduled payments, you will likely be subject to a surrender charge. The surrender charge differs amongst annuity products and companies but the most common penalty is a 7% surrender charge during your first couple of years and then it goes down 1% each year until it is removed. So, if you have only had an annuity for a few years it is likely that you will have to pay the insurance company a surrender charge in order to “cash-out” the annuity. If you have had an annuity for ten years or longer, you are likely able to “cash-out” the annuity without penalty.
IRAs and Annuities
Now that we have the basics of annuities out of the way, let’s get to the questions about annuities and IRAs.
1. Can I buy an annuity with my IRA?
Yes, you can purchase an annuity with your IRA. However, just because you can doesn’t mean that you should. In my opinion, annuities can be part of a well structured financial plan but should be purchased with non- retirement plan (e.g. IRA) funds.
2. Should I buy an annuity with my IRA?
Probably not. One of the benefits of an annuity is that it gives you tax-deferral on the income that is being generated and as a result, using an IRA where you already obtain tax-deferral just doesn’t seem to make sense. If you like the annuity concept of fixed and guaranteed payments, albeit with modest gains from your principal, then you should consider an annuity with your non-retirement plan funds as those dollars aren;t getting any special treatment under the tax code when they are invested. If you already have a large nest-egg of retirement plan funds, why use that set of tax favorable funds to buy an investment product that you could buy with non-retirement plan funds and receive the same tax-treatment. Some say that buying an annuity with an IRA is like wearing a belt and suspenders since your money is already tax-deferred in a traditional IRA. Secondly, annuities are subject to surrender charges and as a result you are locked into that investment and face surrender penalties at the investment level (let alone the account level) if you want to get money out of the annuity to invest in something else or for personal use.
3. How do I get out of an annuity bought with my IRA?
You can usually “cash-out” your annuity owned by your IRA, however, cashing out the annuity to the account value will typically cause a surrender charge. Most annuities have a surrender charge during the first 7 years or so, whereby the penalty is 7% for the first year or two and then decreases 1 percent each year until it is removed. Check with you annuity company or financial advisor in your specific situation though as the products and surrender charges do vary. If you “cash-out” an annuity owned with IRA funds and if those funds are returned to an IRA, then there is no taxable distribution or tax penalty. The only “penalty” would be the surrender penalty by the annuity insurance company. If you take the cash personally though, instead of sending it to your IRA, then those funds are subject to the regular IRA distribution rules and as a result you could be subject to taxes and early withdrawal penalties on the amounts received.
4. Can I roll-over my annuity IRA to a self-directed IRA?
Yes. You can roll-over your annuity IRA to a self-directed IRA. You’ll need to “cash-out” the IRA, pay any applicable surrender charges, and then instruct the annuity company to process a direct roll-over of the funds to your self-directed IRA custodian as a direct rollover. This rollover will NOT be subject to taxes or penalties. Keep in mind though, there may be a surrender penalty though with the annuity company. If there is a surrender penalty, you’ll want to determine whether the benefit and payments owed under the annuity are worth hanging on to the annuity investment or if you are better off simply paying the penalty and moving on to other investment options.
Unfortunately, the annuity and IRA rules can be a little tricky, but once understood you can make informed decisions about how to best use and invest your retirement dollars.