When most people hear the term “IRA” they think Individual Retirement ARRANGEMENT, that mainstay of defined contribution retirement planning. You may have a traditional IRA, you use its cousin the Roth IRA via the backdoor, and you can even rollover your 401K or 403B from work into an IRA after you separate from employment. However, today we're going to talk about another IRA, the individual retirement ANNUITY.
“Annuity?!” you may say. I thought this was The White Coat Investor. Surely he's not going to encourage us to use an annuity after all the bad stuff he has written in the past about not mixing investing and insurance. Relax Tex. Remember there is at least one “good” annuity, the single premium immediate annuity (SPIA), and that's the type of annuity we're talking about today.
What are SPIAs?
There is a lot of talk in the investing and personal finance literature about using SPIAs in retirement. A SPIA insures against your running out of money if you live a long time, longevity insurance if you will. (Although annuity salesmen like to use that term for a type of deferred annuity that is relatively cheap but doesn't pay anything until you're pretty old, like 85 or 90.)
How Do they Work?
With a SPIA, you pay an insurance company a lump sum, and then they send you a check every month for the rest of your life. The older and sicker you are when you buy the SPIA, the larger the check. Interest rates affect your SPIA rate a great deal when you are relatively young (like 50) but much less as you get to be 70 or older. At those ages, the mortality credits have much more to do with the annuity rate than interest rates. Despite today's historically low interest rates, a 70-year-old male can buy a SPIA on himself that pays him 8.12% of the lump sum per year, over double the “4% SWR rate” frequently discussed. That isn't indexed to inflation. If you want the annuity to adjust with the CPI-U, the current rate for that 70-year-old male is 5.9%.
Why Would I Want a SPIA?
Since pensions are going the way of the dodo bird, SPIAs allow you to buy a pension. Since the income is guaranteed, and you are guaranteed not to leave anything behind, you actually end up with a higher withdrawal rate from a SPIA than safe withdrawal rate (SWR) studies show you can have from your portfolio of stocks and bonds. Many people (like most doctors) who arrive at their retirement years with a large lump sum of money from their years of retirement savings but no pension, decide to purchase an SPIA or two with part of their savings to provide a floor to their retirement income. The idea is that the SPIA and Social Security pay for your needs, and your portfolio of stocks and bonds can pay for your wants and any legacy you wish to leave behind to your heirs or charity. You can even ladder SPIAs by purchasing one at 65, one at 70, another at 75, and perhaps one more at 80 as an alternative to purchasing an inflation-indexed SPIA.
Purchasing With a Taxable Account
Purchasing With an Individual Retirement Annuity
However, what if the money you wish to buy the annuity with is now inside a traditional or rollover IRA? What should you do then? There are three choices.
- The first is to pull the money out of the Individual Retirement ARRANGEMENT, pay your full marginal tax rate on it, then buy an SPIA just like in the above example.
- The second option is to buy the SPIA inside the Individual Retirement ARRANGEMENT. The problem with this approach is that you then have to do a complicated calculation each year to determine the value of the SPIA so you can calculate your required minimum distribution (RMD) for the year.
- The last option is to transfer the money from your Individual Retirement ARRANGEMENT into an Individual Retirement ANNUITY. Once you do that, the money is out of the Individual Retirement ARRANGEMENT, and so the RMDs from that account are calculated on the now smaller amount. The monthly payments from the Individual Retirement ANNUITY constitute the RMD. Since that money has never been taxed, the entire monthly payment is fully taxable, just like an RMD from a tax-deferred retirement account.
Example
Assume you're 70 and have a $1 Million traditional IRA. The IRS requires you to take out 3.6%, or $36,000 as your required minimum distribution. If you decide to buy a SPIA with $200K, your traditional IRA now has $800K in it, and your RMD is $28,800. Your SPIA pays 8.12%, or $16,240 which is all taxable. So if you spend your entire RMD, you have a fully taxable income of $45,040, or about 4.5% of the original amount.
Let's say you live to be 90 and thanks to reasonable returns, your IRA is still worth $500K after 20 years of withdrawals. Your RMD on that amount is $43,860, or 8.5% of the total. The SPIA is still paying out $16,240 per year. So your taxable income is now $60,100. Notice that the RMD on an Individual Retirement ANNUITY (the annuity payment) is larger than the “RMD” from an individual retirement ARRANGEMENT in the early years, then eventually becomes lower as you can see in this chart:
| Age | RMD % | 8% SPIA |
| 70 | 3.6% | 8% |
| 71 | 3.8% | 8% |
| 72 | 3.9% | 8% |
| 73 | 4.0% | 8% |
| 74 | 4.2% | 8% |
| 75 | 4.4% | 8% |
| 76 | 4.5% | 8% |
| 77 | 4.7% | 8% |
| 78 | 4.9% | 8% |
| 79 | 5.1% | 8% |
| 80 | 5.3% | 8% |
| 81 | 5.6% | 8% |
| 82 | 5.8% | 8% |
| 83 | 6.1% | 8% |
| 84 | 6.5% | 8% |
| 85 | 6.8% | 8% |
| 86 | 7.1% | 8% |
| 87 | 7.5% | 8% |
| 88 | 7.9% | 8% |
| 89 | 8.3% | 8% |
| 90 | 8.8% | 8% |
| 91 | 9.3% | 8% |
| 92 | 9.8% | 8% |
| 93 | 10.4% | 8% |
| 94 | 11.0% | 8% |
| 95 | 11.6% | 8% |
That's not such a bad deal. You do pay more tax early on using a SPIA, but it's mostly just because you're withdrawing and spending more from your retirement savings. But you should be aware that if your goal is to delay your tax as much as possible (rather than to actually spend as much as you safely can), you might not want to use an individual retirement ANNUITY and just deal with the hassle of having your SPIA inside your individual retirement ARRANGEMENT. But you're getting into a pretty gray area with the IRS since they've never issued guidelines about how to value an SPIA (using a present value calculation of the annuity cash flow) inside an individual retirement ARRANGEMENT. Then again, what's the point of buying an SPIA if you don't want to spend the income from the SPIA each year?
Remember of course that your spending rate and the RMD have nothing to do with each other. You can take out more than the RMD and spend it. You can also take the required RMD out of the IRA and invest it in a taxable account without spending any of it. All the IRS requires is that you take out the RMD. They don't care how much you spend.
An individual retirement annuity is the ideal way to hold a SPIA purchased with tax-deferred money. You avoid the big upfront tax bill that would occur if you withdrew the money from the IRA prior to purchasing the SPIA, and you avoid having to do complex RMD calculations each year.
What do you think is the best way to minimize RMDs when purchasing a SPIA? Have you bought a SPIA using an individual retirement annuity? Comment below!
How does the example play out if you have a ROTH IRA, rather than a traditional? If you use money from a ROTH to buy an SPIA, is the annuity income tax free?
Yes. You can just withdraw the money from the Roth to buy the SPIA.
Well…it’s the old story of how long you’re going to live. You are forking over $200,000 in exchange for $16,240 per year. So it takes you 12 plus years to “break even”. If you purchase the annuity at age 70, and you make it to age 82, then you are ahead of the game for every year you continue to live. Die before age 82 and you haven’t yet consumed your initial annuity payment. That also assumes you would have earned nothing on your $200,000 for 12 years. That is not a reasonable assumption. Hence, your break even is far greater than age 82. What if you were instead, to buy $200,000 of A rated 40 year bonds, which yield 6%. Yes, a little less than the 8.2% annuity. But the payments would continue to be made to your heirs long after your death, and at some point, someone would get back the principal at maturity. I believe these are 2 compelling reasons to opt for the bond strategy vs the annuity. It does not die when you do!
Good point, however bonds do lose money on occasion. But don’t forget that you still need the money to live off of in this scenario so your return on your 200k bond purchase isn’t nearly as impressive when you are reducing the principal by $16k yearly, but still would have better financial effects (assuming no losses) than a SPIA I would think. Unless you vastly outlive your projections.
If you hold a bond until maturity, it does not lose money. You get back your full principal. Yes, if you want to sell a bond before maturity in a rising interest rate environment, the price of your bond will be lower. When you purchase a SPIA, you no longer have the option of getting back some of your principal. Also, there is no reduction in principal. The bond issuer will pay in full at maturity. They do not subtract any of the interest payments.
There’s no reason you can’t do both. Yes, you are likely to do better NOT buying an annuity, but don’t forget the guarantee is worth something. You’re insuring against longevity. Good luck finding a 40 year bond yielding 6%. 30 year treasuries are in the 3% range right now.
In response to Mel, if you’re leery of buying an expensive SPIA and then dying soon thereafter, you can get a guaranteed number of years of payout to your estate, say 10 years, or return of nominal principal. This lowers your payout rate by a fraction of a percent, but can help prevent buyer’s remorse so you’re not on your deathbed regretting that you spent $1M on a SPIA a few months ago and now your heirs are doubly robbed by your untimely demise and lack of a legacy. Generally speaking, though, any insurance/investment product you buy is going to make the company that sells it to you richer, in the aggregate. It only makes sense to buy an SPIA if there is a real concern of outliving your money, in which case you shouldn’t be too worried about leaving your heirs no legacy.
I think a better solution than lowering your rate for a guaranteed payout is to only annuitize a small portion of your portfolio, perhaps 10-25%. That way your heirs still get plenty when you die.
Tax avoidance is never a valid reason to defer income and lifestyle in practice. A similar argument was made for years by estate planners (when the estate tax thresholds were lower and estate taxes were predicted to encompassed more estates than at current rates) as a reason for shrinking or freezing clients’ estates. There’s not a single successful indiivdual I have ever met who wanted to shrink the size of their estate for the prupose of lowering taxes, versus growing their estate and outpacing expected tax liabilities based on net estate values if possible. To say that an investor would avoid taking income, and thus decreasing their lifestyle, so they didn’t have to pay additional taxes is a simplistic and academic argument and one that does not occur in the real world of retirement income planning. Your recommendation of annuitizing a small percentage of the portfolio seems to also undermines the entire premise of your article which is to utilize a SPIA for increased income payouts. If you only annuitize 10-25% of the portfolio, the remainder of the portfolio is still subject to suitable withdrawal rates, which current research shows is likely only 2.5%-3.5% for long term sustainability. The problem with these types of excercises is that they occur in a vaccum, outside the real world, and do not take into account a person’s actual opportunities for both income maximization and tax minimization. Tax loss harvesting, capital gains income, tax free income, chartiable trusts, and a variety of well coordinated strategies can be optimized to generate a a well rounded retirement income strategy. Qualified retirement plans are great wealth accumulation tools. But they fail miserably when it comes to retirement income distribution. They are over funded do to “tax fear mongering” and people are not provided the proper exit strategies that would allow for significant amounts of monies to be withdrawn from these plans without tax. Also, the looming nationalization of retirmeent plans (read: confiscation) due to the unrelenting fiscal irresponsibilities of the federal government is an all too real possibility looming on the horizon. Very quietly, the federal government has been studying how the confiscation of qualified retirement plans would help to fund the government to the toon of $4 tril+ that currently sits in these accounts. What most people do not realize is that you do not own the money in your retirement plan. It is technically held in trust by the federeal gov’t and they can change the rules at any time. Confiscating $4tril to cut into the $17tril debt is quite appealing. I pity all of the Whitecoats who have been blindly lead to believe the great myth of maximizing qualified plans in lieu of investing in individual assets all for the sake of avoid taxes which, effectively, have little impact on the actual income received in retirement when viable alternatives are analyzed. Somebody had to sell the transfer of risk of defined benefit pensions from corporations to the general public in the form of defined contribution plans. The public bought it hook, line and sinker. Ask yourself this: where are all the “success stories” and lead articles in Money mag, WSJ, etc. about the millions of people who go wealthy inside their QRPs…don’t exist.
First, I dispute that the SWR is 2.5%. I’ll buy 3.5%, but give me a break. I can just buy 30 year TIPS yielding 1.5% + inflation right now. Even without equities I can sustain a 2.5% withdrawal rate for 30 years. But at any rate, if the SWR were really 2.5%, then buying a SPIA becomes an even better deal.
As far as success stories of people using boring old 401Ks and Roth IRAs, perhaps you ought to swing by the Bogleheads forum. Polls show that over half of forum members are millionaires. Their advocated approach? Boring old index funds inside retirement accounts. The approach works just fine. If you need a link in Money Mag and the WSJ, you can try these:
http://money.cnn.com/galleries/2012/pf/1203/gallery.bogleheads.moneymag/
http://online.wsj.com/news/articles/SB10001424052702303759604579093733279571044
I find “overfunded” tax-deferred accounts to be quite rare in practice. Studies show that most Americans have less than $100K in retirement. The RMD on a $100K 401K for a 70 year old is $4K. Hardly overfunded. I would argue that you’re not overfunding tax-deferred accounts until you’re at $3 Million or so. What does it take to get there for a 25 year physician career? At 5% real, about $60K a year into tax-deferred vehicles. Most docs just aren’t doing that. If you find you are, start doing more Roth conversions.
Another related approach is to purchase a single premium deferred income annuity and allow it to compound interest tax deferred over a period of years. The interest is guaranteed through the surrender/penalty period (5-10 years usually)and after that there may be a guaranteed interest rate floor. In retirement one can then roll the SPDIA into a period certain immediate income annuity in which the principal plus interest is returned in monthly payments over a specified period of years (usually up to 10). If the owner dies the remaining principal plus interest goes to the beneficiaries or heirs. Although called an annuity the money is not annuitized. This has worked well for me in that as a retired physician at age 72 I now have 4 deferred annuities and have rolled over the first of these into an immediate income annuity and have begun receiving monthly payments north of $1000 for 10 years. The other 3 are continuing to collect 2.5% tax deferred interest and can be rolled over at any time. Any remaining funds after I die will go to my wife or children.
More moving parts means more complexity, and more complexity generally favors the issuer and their agent, not the purchaser. I like the simplicity of immediate annuities and see no reason to take an intermediate step between traditional investments and an immediate annuity. Could it work out okay? Sure. But I see no reason for a general recommendation for doing that.
Very sound, logical approach. One question though? Are you saying that the annuity continues to pay throughout your life? Or does it go away after 10 years? And is it only during that 10 year period that if you die, the remaining 10 years worth of payments go to your heirs?
I found this page several years ago, and now I have some burning questions…
In 2009, at age 59, I purchased two Variable Deferred Annuities with IRA funds. I commenced both in 2020, with their Distributions rolling-over directly into my Traditional IRA. I will turn age 72 in 2022, and will need to take RMDs, and your article above makes me wonder if the latent Contract Value of each Deferred Annuity on Dec 31 of each year is added to my Traditional IRA Dec 31 balance to determine the following year’s RMD, OR if only the Traditional IRA balance is used.
Details of the Annuities are:
Each year, each Annuity makes a constant Distribution that Rolls-Over into my IRA, so there is no “income” from the Distributions. The Annuity Contract Values are adjusted downward by the amount of the Distributions, and the Contract Values continue to adjust, based on the market impacts to their underlying portfolios throughout the year. The Annuities are considered “RMD Friendly”, indicating that each Distribution satisfies its own RMD…
Your article addresses SPIAs, and indicates that each Distribution satisfies the SPIA RMD.
So in my case, can I calculate my RMD based on the Traditional IRA balance alone, or must I add the Annuities Dec 31 Contract Values to my IRA Dec 31 Value to determine the RMD?
My thanks in advance for your consideration of this question; please feel free to include it on your web page, because I believe others may be interested in the answers.
That’s a great question. My guess is that you’ve got to take out your annuity distribution AND the RMD based on the value of the rest of the IRA. But you need to run that by an accountant or find the answer at irs.gov because I’m not sure at all about this.
You may be right as well that you need to add the annuity value before calculating the RMD. Luckily we have a couple of years to figure it out. I’ll see if I can find the answer too.
Here is what I have learned since my previous post:
1) The RMDs for each Annuity, and for my Traditional IRA are summed to calculate the total RMD I must satisfy.
2) My Annuities are considered “RMD-Friendly”, which means if the Contractual Annual Distribution falls short of the Annuity’s RMD, I am allowed to increase the Distribution to meet the RMD, with NO penalty from the Annuity company.
3) When the Annuity’s Contractual Annual Distribution exceeds its RMD, the excess can be applied to the RMD of my Traditional IRA.
Distributions from all three investments are summed to meet the combined total RMD.
– – – – – – – –
Yet another scenario has since occurred to me:
If I Annuitize the Variable Annuity, its Contract Value will fall to Zero, and I would receive an annual Distribution calculated at the time of the Annuitization… Would the Zero Contract Value mean there would not be any calculated RMD for that Annuity? …or has the IRS made a ruling that addresses this?
My thanks in advance for your point of view on this twist.
I think the assumption is that the annuity payment = the RMD.
I believe that the only number you must use is the actual value of the IRA at 12-31 of the prior year. In other words, what would the dollar value be if liquidated? Hypothetical, latent, projected mean nothing.
I used my 403B at the age of 70 to purchase a SPIA with a rate of return of 8.184%. My RMD requirement would have started at 70 1/2 and I found an SPIA to be the best solution for securing the highest guaranteed lifetime income. I do not see any real downside to purchasing an SPIA, unless you are in poor health. I have been collecting my annuity for a few years now and I can tell you, I am very happy . It is very satisfying and comforting to have guaranteed lifetime income. It is a great supplement to my other income and allows me to spend more freely.
Thanks for sharing your experience.
I realize that the 8.18% “return” is very enticing, especially in this low interest rate environment. But the “return” is only a RETURN of your own money for the first 12.5 years. And again, that assumes that any investments you would have made with the money from your 403B would have produced NOTHING during that 12.5 year period. Not a reasonable assumption. So it would really be more than 12.5 years before the insurance company had to use any of their OWN money to dole out your 8.18% payments. And just FYI…effective January 1, 2020, the beginning age for RMD’s was moved from 70.5 to 72.
Yup, only buy an annuity if you find the guarantees valuable.
Based on the updated section 204 (below) from the SECURE 2.0, do you have a view if the withdrawal from the annuity (held as part of an IRA) will satisfy RMD? This assumes that the IRA holds annuity as well as other investments. Thanks
Section 204, Eliminating a penalty on partial annuitization. If a tax-preferred retirement account also holds an annuity, current law requires that the account be bifurcated between the portion of the account holding the annuity and the rest of the account for purposes of applying the required minimum distribution rules. This treatment may result in higher minimum distributions than would have been required if the account did not hold an annuity. Section 204 permits the account owner to elect to aggregate distributions from both portions of the account for purposes of determining minimum distributions and is effective on the date of enactment of this Act. The Treasury Secretary is to update the relevant regulations accordingly
Yes, I would expect it to continue to satisfy RMD requirements for a minimum of the annuitized portion and a maximum of the entire RMD.