More On Tax Planningfrom The Advisor's Professional Library
- Selected Provisions of the American Taxpayer Relief Act of 2012 The experts of Tax Facts have produced this comprehensive analysis of selected provisions of the American Taxpayer Relief Act of 2012 (the Act) to provide the most up-to-date information to our subscribers. This supplement analyzes important changes to the tax code with emphasis on how these developments impact Tax Facts’ major areas of focus: Employee Benefits, Insurance, and Investments.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
Annuities can be purchased inside an IRA, but is an IRA the right home for an annuity? The debate has raged for years and the answer depends on which advisor you talk to.
But considering the fact that as many as one-half of variable annuities sales are made in an IRA rollover, the question is key for all annuity producers. The answer turns on whether the producer can sufficiently separate and identify the tax and non-tax client objectives that justify selling a tax deferred product to a tax exempt plan.
No Double Deferral
There’s no such thing as double tax deferral, leading to the biggest client complaint of all about purchasing an annuity in a tax deferred account such as an IRA: An annuity doesn’t offer additional tax deferral when purchased in an IRA, eliminating one of the product’s primary selling points.
Instead, many financial services professionals recommend purchasing investments, such as stocks, that do not otherwise offer tax deferral in a tax deferred account; and if there’s money left over, consider purchasing an annuity outside the account. An investor can sock away only $5,000 a year in an IRA, why “waste” some of the account’s funds by buying an annuity?
If you’re going to sell an annuity into an IRA, tax savings definitely won’t cut it as a justification.
The preceding arguments are based on the assumption that annuities are purchased only for their tax deferral benefits. But annuities offer benefits beyond just tax deferral. If an annuity is a better option than other safer investments in an IRA, there’s no inherent reason not to purchase an annuity in an IRA.
Why are you recommending that your client purchase an annuity in their IRA?
Annuities offer features that other “safe” investments do not. Annuities can include guarantee riders—such as death benefits, guaranteed crediting rates and guaranteed withdrawal benefits—that may motivate a client to make the purchase. Many retirees are still spooked by memories of waking up during the recent financial crisis to find that their retirement accounts had dropped as much as one-third in value. These risk adverse individuals may find that annuities offer them the security they crave. As long as they aren’t making the purchase for tax-deferral purposes, why not make the right purchase regardless of where it will be held?
Have you documented the non-tax reasons for recommending the purchase?
Many advisors counsel their clients against purchasing an annuity in their IRA because of the expenses associated with annuities. This reasoning is not related as much to the interface between annuities and IRAs, but is more a general criticism of annuities as an investment product. The argument goes, “Why purchase an annuity in your IRA when you can get a better return from another investment product with lower fees?”
As written by contributor David Sterling earlier this year, “Will a Cessna satisfy your needs when you are looking for a sailboat?” The primary appeal of annuities is usually their contribution to retirement security and income sufficiency, not unlimited upside or total return. If a client’s primary concern is income sufficiency, and an annuity is the best product to get them that security, does it matter where the annuity sits?
Have you offset the expenses associated with the annuity with non-tax needs that the annuity will satisfy?
Anyone who may be interested in converting their conventional IRA to a Roth IRA needs to understand the rules about Roth conversions involving an annuity. The Roth conversion rules are simple enough, but throw an annuity into the mix and the conversion process gets far more complicated. Advisors must be aware that the fair market value
Valuing an annuity for Roth conversion purposes is a complex process involving multiple valuation methods. Which method is appropriate will depend on how long ago the policy was issued, whether comparable contracts are available for comparison, and whether the contract has been annuitized. Throw a guaranteed benefit or other rider into the mix and the valuation is much more complicated.
The key point to take away from this discussion is that the value of an annuity for Roth conversion purposes may be much higher than its fair market value. Although your clients can rely on their 1099 to report the value of the annuity for conversion purposes, they must understand in advance that market losses may not have the same effect on the conversion as they do when securities are held in the account. Just because the market tanked prior to the Roth conversion doesn’t mean their annuity will be valued significantly lower for Roth conversion purposes than it would have been before the crash.
Critics will tell you that an annuity should never be purchased in a tax deferred account such as an IRA because double deferral is impossible. But if an annuity is the right product for your client and they aren’t making the purchase for tax deferral purposes, then purchasing an annuity in an IRA isn’t a bad idea. If tax deferral is their primary goal, another investment inside the account may be a better fit.
When considering a sale of an annuity into a retirement plan such as an IRA, you would be wise to start with the presumption that the sale is inappropriate and proceed from there. If after establishing and documenting your client’s objectives, you’ve overcome that presumption and conclude that an annuity is the right purchase in their IRA, you can make the recommendation with confidence. Retirement income security is a big concern for investors at all asset levels, and annuities can be a great solution.
Why shy away from a product just because prevailing wisdom would recommend against it?
Annuities are not the right fit for many clients’ IRAs, but you are not doing your duty to your clients if you don’t recommend annuities where appropriate.
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See also The Law Professor's blog at AdvisorFYI.