Annuities are appealing to many investors because they offer tax-deferred growth and the potential for guaranteed income that you cannot outlive. The tax-deferred growth is similar to the features of a 401(k) or a traditional IRA. While certain retirement accounts are subject to required minimum distributions (RMD), those same rules can apply to annuities as well. This specifically applies to annuities that are housed within an IRA, 401(k) or other retirement account. If you’ve got questions about annuities, RMDs or retirement planning in general, consult with a financial advisor.
Annuity RMDs: When Do They Apply?
Tax-deferred investments, like annuities, 401(k)s, and traditional IRAs, allow your money to grow without paying taxes each year. During this time, the government does not collect revenue on any growth. However, depending on when you reach age 70.5, you’ll need to begin withdrawing a minimum amount from certain accounts at either age 70.5 or 72. These are called required minimum distributions (RMDs), and they only apply to annuities that are housed within a separate IRA, 401(k) or other retirement account.
Here’s how to tell which RMD age bracket you fall in: Let’s say you turned 70.5 in 2019. In this case, you must take your first RMD at 70.5. On the other hand, let’s say you turned 70.5 in 2020 or later. For these individuals, your first RMD must be by April 1 of the year after you turn 72. So if you turned 72 in 2022, then your RMDs must start by April 1, 2023.
RMDs are based on your portfolio size, age and expected lifespan according to the IRS’ “uniform lifetime table.” RMDs start out around 4% of your retirement portfolio balance and increase as you get older. This means that each year you’re required to withdraw a larger percentage of your account balance than the year before.
The government charges a steep excise tax penalty of 50% for required amounts not taken by the deadline. This excise tax is on top of the normal income taxes on withdrawals and any other penalties and interest that may apply.
Who Has to Take an Annuity RMD?
Because annuities offer so many benefits that are attractive to certain investors, sometimes they are held within a retirement account. These accounts are known as “qualified annuities” because they are held in a qualified retirement account. Qualified retirement accounts include traditional IRA, 401(k), 403(b), 457, SEP-IRA, and similar accounts.
Qualified annuities must follow RMD rules just like any other stocks, bonds, or investments held within that retirement account.
Roth IRA and Roth 401(k) accounts do not require minimum distributions, so annuities held in those accounts are not subject to RMDs. Since Roth contributions are made with after-tax money, they are considered non-qualified retirement plans.
Many annuity benefits are lost when held in a qualified retirement account. When you hold an annuity in a qualified retirement account, you lose out on four important benefits:
- Tax-deferred growth: Retirement accounts already offer tax-deferred growth, so there’s no additional tax benefit from the annuity.
- No contribution limits: Even though annuities do not have contribution limits, your retirement account contribution limits are based on those rules instead. For example, traditional IRA contribution limits are $6,000 per year ($7,000 for those 50 and older).
- No mandatory withdrawals: Withdrawal requirements are determined by the retirement account. Annuity RMDs are required once you reach 72 years of age.
- Tax-advantaged withdrawals: When you withdraw from a retirement account like a 401(k) or traditional IRA, every dollar of the withdraw is considered taxable income. Both the principal and earnings withdrawn are subject to income taxes.
Features to Be Aware of With Annuities
Annuities offer many attractive features for investors. These benefits include:
- Tax-deferred growth: Growth in your account balance does not require annual tax reporting or payments.
- No contribution limits: Unlike retirement accounts, like a 401(k) or IRA, there is no limit to how much you can contribute to an annuity.
- Choice of investment options: Depending on the company, your annuity can invest in a variety of investments, including fixed income, stock accounts, and more. Fixed annuities offer returns similar to CDs or bonds, while variable annuities can be invested in accounts similar to mutual funds.
- Flexible withdrawal strategies: When you’re ready to start withdrawing, you can withdraw a lump sum, set up periodic withdrawals, or annuitize your balance for lifetime income.
- Lifetime income benefits: An annuity’s unique advantage is that it can provide guaranteed lifetime income that you cannot outlive. This addresses one of retirees’ biggest fears.
- No mandatory withdrawals: While retirement accounts require RMDs at age 70.5 or 72 (depending on when you reach 70.5), you are not required to start withdrawals at any age. The only exception is if your annuity is held within a retirement account.
- Death benefit to beneficiaries: Annuities include an insurance component that guarantees a death benefit to your beneficiaries if you die before withdrawals begin, even if your account balance has dropped due to market performance. Annuity distributions generally also avoid probate.
- Tax-advantaged withdrawals: When you annuitize your account balance, your monthly payments are a combination of principal and earnings. This means that a portion of your payment is a return of your investment, which is not taxable.
Annuities generally are not subject to RMD rules. You do not have to start withdrawing at age 72 and there is no minimum withdrawal required. However, when an annuity is owned by a qualified retirement plan, then you must meet annuity RMD withdrawal amounts each year. If not, you’ll owe an excise tax of 50% of the amount that you were supposed to withdraw, but didn’t. When you add in taxes, penalties, and interest, the government could take close to 100% of your required minimum withdrawal amount.
Tips for Investing
- An annuity can be an important part of your retirement income strategy. To determine how much income that you’ll need to meet your retirement goals, use our retirement calculator to determine how much you’ll need to save for retirement.
- If you’re considering investing with an annuity, we recommend speaking with a financial advisor who can help you compare the pros and cons of each product. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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