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Annuities and Roth IRAs: A Dynamic Duo


photo_39163_20150706For some investors, the capital commitment, tax treatment and complexity are enough to keep them from looking into purchasing an annuity. And or some, it isn’t a wise option, especially as a standalone product. But when combined with a Roth investing strategy, an annuity investing strategy can make a lot of sense. A recent article from ThinkAdvisor detailed the dynamic relationship between a Roth IRA and an annuity. Here’s a brief summary.

For the right client, adding a Roth IRA into an annuity investing strategy can help reduce the potential downsides. It can provide a more favorable tax scenario down the road and alleviate any negative implications associated with an investment of such a large sum of money. Here’s how:

The future tax treatment of an annuity income stream is problematic for some clients. While annuities generally have positive tax attributes, any growth of the account value will eventually be taxed as ordinary income. Many other long-term investments are taxed at the lower capital gains tax rate, which obviously is attractive to many would-be annuity buyers. Here’s where the Roth IRA comes in.

When purchased with Roth IRA funds, any annuity distributions will be governed by Roth IRA tax rules. This means that any distributions from the annuity contract will be received tax-free in the future because the client pays taxes on the funds when contributed to the Roth. Combining the annuity and the Roth means that the client will receive lifetime income benefits from the annuity, with the tax advantages of a Roth IRA.

There is a little catch of course. In order for the distributions to be received tax-free, the distribution rules that apply to Roths must be followed. This means that the investment typically must remain in the Roth for at least five years before it is withdrawn. Also, if the client has not reached the age of 59 ½, any withdrawals will partially tax-free, meaning that contributions are tax-free, but earnings on those contributions are taxed.

Another reason why clients shy away from annuities is because it requires investment of a large sum of money that the client won’t be able to access without penalty, often for many years. Yet again, the Roth annuity comes to the rescue. The rules that govern a tax-free Roth IRA state that funds must remain in the account for at least five years in order to take advantage of the valuable tax benefits. Most clients who invest in a Roth want to keep their funds in the account for as long as possible so that they can achieve the best tax-free growth possible. A Roth annuity makes sense as a long-term investment for clients who are looking for lifetime income.

This all sounds too good to be true, right? Of course there are some pitfalls with this strategy. For example, even though the tax benefits of the Roth annuity are substantial, the large expense of purchasing one may outweigh those benefits for some. Keep in mind, annuities can come with additional riders that add guarantees and features, for an additional cost of course. It is crucial that the client uses caution when selecting the annuity to be sure that it contains only features they want or need. Also, the issue of surrender charges is important to discuss. While these charges are often mitigated by the fact that Roth IRA investments are generally long term, if a client is concerned about needing any funds in an emergency before the surrender period is over, an annuity may not be the best choice.

For the right candidate, a Roth annuity can be a viable alternative to traditional annuity investing. By combining the tax benefits of the Roth with the income security of an annuity, this strategy can provide both peace of mind and smart money management. As always, it is recommended that you discuss any financial decisions with a trusted financial advisor before signing on any dotted lines.

Written by Rachel Summit

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