Annuitizing an IRA

Annuitizing an IRA

Which set of distribution rules should you use?

by Natalie Choate 02-11-11

Question: A 70-year old client owns a variable annuity contract inside his IRA. The contract provides a guaranteed life income feature that begins whenever the client triggers it, and overrides the value of the underlying investments. To provide retirement income for himself, the client triggered the provision upon reaching age 70, at a time when the contract's cash value base was $1,000,000, so now he is guaranteed to receive six percent of that cash value ($60,000 per year) for the rest of his life. The cash value of the contract will continue to be adjusted upward and downward for changes in the value of the underlying investments and to reflect distributions, but as long as he does not make any withdrawals in excess of the $60,000 per year the payments to him will continue for life even if the cash value of the contract goes below zero. Furthermore, if there is still a cash value at his death, it will pass to his beneficiary. How is this contract treated for minimum distribution purposes?

Natalie: The IRS has one set of minimum distribution regulations for "defined contribution plans" (also called "individual account plans") and another set for "defined benefit plans" (including defined contribution plans that have been "annuitized"). The two sets have completely different rules and are based on completely different concepts. In fact, if an IRA has been partly "annuitized," the IRA is treated as two separate plans for minimum distribution purposes-one set of rules applies to the annuitized portion, and the other set of rules applies to the rest of the account.

The defined contribution rules are the most familiar: The annual minimum required distribution is computed by dividing the prior year-end account balance by a life expectancy factor obtained from an IRS table.

The defined benefit/annuity minimum distribution rules take a different approach. There is no concept of computing an annual distribution, and no need to look at a prior year end account balance. Instead, these rules dictate what type of annuity can be purchased by an IRA or other retirement plan. Basically, only life annuities, or joint life annuities with the designated beneficiary, are allowed, but there can be annuities for fixed terms (or with minimum guaranteed terms) that do not exceed the applicable life expectancy. Payments under the annuity must be level, or increase by no more than a cost of living adjustment or specified fixed annual percentage. Once the annuity is in place, all distributions under the contract are considered "minimum required distributions."

And the IRS rules specify that a variable annuity contract, until it is actually "annuitized," is treated as just another asset held inside an individual account plan, with special valuation rules that apply.
 

The trouble with this neat little bifurcated universe is that the insurance companies keep coming up with new hybrid products. It's not always clear which set of rules applies to these products. Your client's guaranteed income variable annuity is a perfect example. It has a cash value (so to that extent it behaves like a defined contribution/individual account plan) but it also has a guaranteed life income feature (like a true annuity).

Recently, the IRS ruled that a similar sort of guaranteed withdrawal product had to be treated as an annuity contract for purposes of the spousal consent rules applicable to qualified retirement plans (spousal consent required in order for employee to take retirement distributions in any form other than a qualified joint and survivor annuity). But as yet there are no IRS pronouncements on how the minimum distribution rules apply to these hybrid contracts.

There are two minimum distribution concerns we would have about a product like this:

* First we want to be sure that the contract complies with the minimum distribution rules.

* Second we need to know the status of distributions the client receives; any distribution that is a minimum required distribution cannot be rolled over.

Until there is an IRS pronouncement, a client may be forced to be cautious and conservative regarding how the minimum distribution rules may apply.

One thing is clear: The life annuity itself does not violate the minimum distribution rules, because it lasts only for the client's own actual life. The defined benefit/annuity minimum distribution rules always permit an individual to buy a level payment single life annuity for his own life.

The potential compliance problem that arises would be if the cash value of the account increases beyond what is needed to support the $60,000 life annuity. The only way the client can be sure he is complying with the minimum distribution rules is to withdraw from the account, each year, the $60,000 minimum guaranteed payment, or (if greater) the minimum distribution computed based on his age and the prior year-end cash value. Such extra withdrawals might impair his guaranteed income stream, unless the contract has an exception permitting minimum required distributions to be made without prejudice.

The next problem is whether each $60,000 annual distribution is considered a minimum required distribution, which would be the case if this is treated as an "annuitized" IRA. If the guaranteed payments are considered minimum required distributions, they cannot be rolled over to another IRA.

For many clients, these questions will not be of significant concern because (1) in many cases there is almost no chance the cash value will increase after the guaranteed payout begins and (2) in most cases the guaranteed income payments are for spending, with no desire to "roll them over" into another IRA. However, for clients who may wish to roll over some of their guaranteed payments, and/or where cash value may grow significantly, the insurance companies issuing these products may wish to obtain an IRS ruling regarding their minimum distribution treatment.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed in this article are the author's.

One Year Checklist to Retirement

 One-Year Checklist to Retirement

One of the biggest lessons of the recent economy is that many people who thought they were financially ready for retirement…weren’t.

The amount of money, investments and government support you’ll need to retire comfortably is as individual as you are. Some people plan to work in retirement. Others have health issues or other financial responsibilities – kids’ college bills, financial support for a senior relative -- to juggle with the everyday living expenses they’ll face in retirement.

However, one thing is true for every potential retiree. It makes sense to get customized advice from qualified financial, tax and estate planning professionals at least one year before a retirement date is set. Here are some preparatory steps to take before you seek that advice and finally set a retirement date. 

Figure out where the money is: The days of single-employer careers have been over for decades. And nearly 30 years into the world of widespread IRAs, 401(k) and other self-directed retirement plans, many potential retirees can’t reliably state where all their retirement resources are. Start pulling together all available paperwork tracking personal, government and employer-based retirement assets get them into order. It’s OK if you don’t know immediately whether you have enough to retire – experts can help you with that. What’s important right now is to identify everything you have so you can properly evaluate alternatives.

Identify debt: If you have significant home or consumer debt, that’s a tough burden to take into retirement because most retirees find their income will be somewhat or significantly lower. That also goes for big car payments, tuition debt, medical debt or elder support. Debt is the first major reality check on retirement for most people.

Adopt a downsizing budget: Too many people wait until retirement to learn how to live like retirees. If you have a budget, review it for unnecessary spending that could mean anything from cutting back on lattes to selling a bigger, more expensive car and going with public transit or a used vehicle. If you’ve never made a budget, now’s the time. Budgeting for retirement doesn’t mean cutting out every treat and luxury – it simply means extinguishing debt, setting priorities and determining which current expenses can be cut or eliminated. As the real estate market recovers, you may want to plan to sell your current home in favor of a smaller one that can be bought for cash or minimally financed, or possibly you might decide to rent. You might want to try “going smaller” with vacations, cars, clothes and other needs or wants that can move to a lower price point. Do this while you’re working, bank the money you save and you’ll have excellent training wheels for retirement.

Evaluate your support from the government: A good rule of thumb is, “If you need Social Security or Medicare to retire, it’s best to keep working.” While both of these programs remain enormous help to many retirees, there’s always a chance of significant change in these programs, not to mention the continued discussion of moving the official retirement age well past 65. Definitely evaluate your government benefits, but do so in the context of what you’ve accumulated privately so you can maximize your government benefits when you need them.

Consider healthcare and long-term care NOW: If you’re lucky, your health is in great shape. But family history and events out of the blue may change that. If you retire before age 65, you won’t qualify for Medicare unless you are officially disabled. That means that you’ll have the responsibility to maintain private insurance that adequately meets your needs without huge financial risks that can come from uninsured care or procedures.  Even as healthcare reform adds certain protections for under-65 policyholders, it’s more important now than ever to give attention to health matters and whether your current insurance strategy is adequate. As for long-term care, many Americans still forget that the bulk of home-based and nursing home care must be paid out of pocket. While long-term care insurance exists, age and health needs can potentially make it very expensive, so this is another important financial planning issue.

Find out if your dream retirement really works: It’s important to test your retirement dream. While many people dream of moving to a particular place, it’s important to vet that choice for financial and lifestyle repercussions. A particular location might have cheap housing and great healthcare options, but what about cultural attributes and tax issues? There are literally dozens of factors that should enter into your post-retirement lifestyle decision, and to jog your thought process, Nolo provides a checklist that might help.

Feb 2011 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by James P.  Ellman, ChFC and Barry Mendelson, CFP,  local members of FPA.