Annuity Inside an IRA? Take a Careful Look
Variable annuities offer tax-deferred growth. Individual retirement accounts offer tax-deferred growth. So does it makes sense to place a variable annuity inside an IRA?
In general, no. Not only would you wind up with extra restrictions on your money because of the redundant layer of tax shelter, you would pay more for the privilege. Variable annuities are more costly than mutual funds held inside of IRAs, to which they’re commonly compared. As a rule of thumb, it’s best not to mix different tax-sheltering vehicles in one account.
Yet in certain situations, the combination can make sense. Variable annuities have become less costly, which makes the tax-shelter redundancy less onerous. Besides, some annuity traits could come in handy for IRA investors.
“Conceptually, combining the two is a bad idea,” says Jennifer Strickland, a variable annuity specialist for Morningstar Inc. of Chicago. “But in practice, it might not be so bad.”
In fact, variable annuities often wind up in IRAs, especially “rollover” IRAs that serve as tax-sheltered repositories for money cashed out of employer pension plans. The vast majority of annuity money that goes into IRAs enters in this fashion, says Richard Ford, pension-marketing manager for Safeco Life in Seattle.
The main criticisms of variable annuities revolve around their cost. As insurance products, annuities carry an extra layer of expenses that pay for their unique features.
A recent study by Lipper Analytical Services of Summit, N.J., found that variable annuities are more expensive than straight mutual funds by 0.54% a year on average. That’s not a huge drag, but it’s enough to make a difference over time. Besides, certain annuities can be much more costly, so it pays to shop around, Strickland says.
What extra features do you get for the additional outlay, and are they wasted inside an IRA? Here’s a quick checklist that provides some answers:
* Guaranteed death benefit. Part of the higher annuity fees pays for modest insurance coverage that guarantees your heirs will get back at least what you invested, less any withdrawals, regardless of what happens to stock or bond prices. Some annuities increase this guaranteed base every few years.
“This guarantee encourages some people to take greater investment risks than they otherwise would,” Ford says.
Aside from the psychological comfort, the feature would come in handy if you died during a bear market, shortly after buying an annuity.
But over many years, your investment dollars will almost certainly appreciate anyway, probably well beyond the minimum death benefit. So your heirs, most likely, never would make use of this feature. And you can buy life insurance directly as you need it.
* Flexible-payout options. Annuities offer various ways to cash out money over the years. These options are complex enough to fall beyond the scope of this article. Suffice it to say that some can work in your favor and others against you, depending on how well you estimate factors such as your life expectancy.
Nevertheless, the fact that it’s easy to set up a formal payout plan with annuities could be helpful for IRA investors. These people must start withdrawing money shortly after they turn 70 1/2 years old, and they may have to recalculate a new withdrawal amount each year.
By formalizing a payout schedule through an annuity, you would automatically comply with the IRA requirement, says Ryan Johnson, national sales director for Guardian Investors Service in New York. “You wouldn’t have to recalculate your IRA withdrawal requirement each year.”
* Mandatory withdrawal age. Ironically, one advantage variable annuities enjoy would be lost inside an IRA. This involves the age at which you have to start taking out money.
IRA investors, as noted, must start withdrawals soon after they turn 70 1/2. But investors in straight annuities don’t have to begin until age 85 or beyond, depending on the contract, unless the cash is held in an IRA, in which case the 70 1/2 requirement would apply. Thus, placing an annuity inside an IRA would work against annuity investors who want to let their cash grow as long as possible.
* Switch privileges among funds. Inside an annuity, you can move money among investment portfolios without incurring taxes each time. A typical annuity might offer a choice of a dozen funds from three money managers, Strickland says.
But you can switch among an even wider choice of mutual funds inside a one-stop brokerage IRA program, such as those offered by Charles Schwab and Fidelity Investments.
“One reason not to put an annuity inside an IRA is that you give up flexibility when it comes to investment choices,” says Mark J. Smith, a certified public accountant and financial planner in Aurora, Colo. Few annuities offer more than 20 investment choices, he says.
As these examples demonstrate, variable annuities are not simple instruments, and they become even more complex inside IRAs. These complications in themselves are a good reason not to place the two vehicles under the same roof.
Yet it’s also not fair to characterize all such combinations as ridiculous. In some cases, placing a variable annuity inside an IRA could be a sound move.
