Annuity contracts provide monthly income for a set period or for the rest of your life. There are many types of annuities, but all work on the basic premise that first you put money (i.e., the premiums) into the contract, and then begin receiving payments from the contract as of the annuitization date. You might receive a single lump-sum payment on the annuitization date or the first of a series of monthly annuity payments.
For immediate annuities, the annuitization date is approximately the same date you contribute a lump-sum premium to the contract. In a deferred annuity, the annuitization date occurs some time after you contribute your first premium. The first premium might be a lump sum or the first of a series of contributions to the contract. The rules for minimum distributions depend on whether the annuity is qualified or non-qualified; annuities are also categorized as fixed or variable.
Understanding Annuity Basics
You can buy an annuity with a set term, or a _single life annu_ity that will pay income for your entire life. The amount you receive depends on the length of the payout period, your age and the annuity’s cash value, and in the case of a variable annuity, your investment performance. The cash value grows without creating taxes – you only pay taxes when money is distributed from the annuity. On the annuitization date, you stop paying premiums and begin receiving income. The contract issuer will assess fees to cover the costs of life insurance (if any), contract administration and investment management.
The fair market value of a deferred annuity can be difficult to determine. Factors affecting fair market value include the annuity’s purchase price, its cash value, applicable minimum guarantees and riders that add value. Knowing the fair market value of an annuity is important when determining RMDs. Generally, the year-end fair market value of an annuity is available from the issuer and can be used for RMD calculations.
Most annuities charge a surrender fee if you cash out the contract before the payout phase begins. Surrender fees can exceed 10 percent but usually decline over time. If you choose, you might be able to perform a S_ection 1035 tax-free exchange_ to replace your current annuity with another one, but you will have to pay any surrender charges in force at the time.
Exploring Insurance Features for Annuities
You can add insurance features to an annuity. Normally, the annuity stops paying when the owner dies, and the issuer retains any remaining cash value. You can add a feature guaranteeing a minimum number of payments if you die during the guarantee period. Your beneficiary collects the remaining payments.
In addition, you can add a death benefit to the contract that pays a lump sum or a stream of payments to your beneficiary upon your death. If you buy a survivor annuity, the beneficiary continues to receive payments for life.
Comparing Fixed vs Variable Annuities
Fixed annuities invest your premiums at a set interest rate, whereas variable annuities can be invested in stocks, bonds and mutual funds. Fixed annuities offer a guaranteed interest rate for a set number of years, where the length of the guarantee depends on the issuer and the contract. If the guarantee period ends, the annuity grows at a rate determined by the issuer, and that rate can change every year. In a fixed annuity, once you start receiving monthly payouts, the amount never changes for the entire payout period, unless you buy an inflation-protection feature.
In a variable annuity, the payout amounts depend on the cash value of the contract. The cash value equals how much money you contributed (after fees and insurance premiums) and how much money your contributions earned through investment.
The rules for a fixed or variable annuity required minimum distribution policy applies only to qualified annuities.
Comparing Qualified vs Non-Qualified Annuities
In a qualified annuity, you pay your premiums with pretax income. That is, you exclude from your current year’s taxable income the premiums you pay into the contract for the year. A qualified annuity resides in a tax-advantaged plan, such as a traditional IRA or a qualified employer-sponsored retirement plan – a 401(k), 403(b) or 457 plan. You must pay taxes on the money distributed from a qualified annuity, and these distributions are taxed as ordinary income at your then-current tax bracket.
A non-qualified annuity contains contributions from post-tax income. In other words, you have already paid income tax on these contributions. These annuities do not have required minimum distributions. However, you must start taking annuity distributions on the annuitization date specified in the policy.
For a non-qualified annuity, you only pay taxes on the portion of these distributions that stems from the growth of your annuity’s value due to your investments. Thus, although you cannot deduct non-qualified annuity contributions, your money grows tax-deferred and you pay tax only on the portion of distributions resulting from your earnings.
Figuring Qualified Annuity RMD Deadlines
The year you reach age 70 ½ is called the starting year. However, non-IRA qualified annuities might permit you to postpone your starting year if you are still employed. This postponement doesn’t apply if you own 5 percent or more of the business.
You must begin taking payments from a qualified annuity in the year after your starting year. Specifically, you must take your first RMD by April 1 of the year after the starting year – this is the required beginning date – and the second RMD by Dec. 31 of that same year. Thereafter, you must take annual RMDs by the end of each year.
After the required beginning date, you must annually withdraw an amount no less than the RMD, although you are free to withdraw more. But withdrawing a surplus amount in one year doesn’t reduce your RMD in subsequent years. However, if you withdraw money in the starting year, it counts toward the RMD due by April 1 of the following year. If you fail to take an RMD, the IRS will slap a 50 percent excess accumulation penalty on the amount not distributed.
Calculating Your RMD After Annuitization
Typically, the annuitization date for your annuity contract coincides with your 70 ½ birthday. In this circumstance, your RMD for any given year is based on the annuity’s fair market value as of the end of the previous year. The amount is equal to the contract’s fair market value divided by your distribution period, which is based on your age on that year’s birthday.
You can look up your distribution period on the RMD table of the IRS Required Minimum Distribution Worksheet. For example, suppose the fair market value of your qualified annuity is $110,000 on Dec. 31 of the previous year. This year, you turn 76, to which the IRS Worksheet assigns a distribution period of 22 years. Your RMD this year is $110,000/22, or $5,000.
If your IRA or qualified retirement account contains assets other than your annuity, you will need to separately calculate and pay the RMD on these assets.
Calculating Your RMD Before Annuitization
It’s quite possible that your annuity contract has an annuitization date later than the year you reach age 70 ½. In that case, it’s fair market value counts as another asset in your traditional IRA or qualified retirement account until the annuitization date. Therefore, your RMD calculation for that account must include the value of the annuity until annuitization occurs. The RMD must be paid using non-annuity assets in the account.
Eventually, the annuity contract will annuitize if not first cashed in. You calculate your RMD in the annuitization year based upon the previous year’s ending balance for the IRA or retirement account. The annuity’s RMD for the first year must come from the annuity payments you receive that year. If they don’t, you’ll have to take the money from non-annuity holdings in the account.
In subsequent years, you don’t include the value of the annuity when calculating the account’s RMD. In other words, you pay two, non-overlapping RMDs each year following annuitization – one for the annuity and the other for non-annuity assets.
By the way, the annuity payout you receive might be greater than the annuity’s RMD for the year. Unfortunately, you can’t use the excess to cover any of the account’s non-annuity RMD.
Avoiding RMDs with an Immediate Annuity
An IRA or qualified retirement account can hold qualified immediate and/or deferred annuities. An immediate annuity is a contract in which you contribute a lump sum of money in return for a stream of fixed annuity payments that begin right away. That is, the date of your single contribution is when the contract is annuitized, or shortly thereafter.
As such, the contract never has a cash value, and therefore has no basis for determining an RMD. An immediate annuity does not figure in the calculation of the account’s RMD and has no RMD requirement of its own.
Understanding Qualified Longevity Annuity Contracts
In 2014, Congress addressed an oft-expressed concern about seniors outliving their money. In that year, it created qualified longevity annuity contracts, or QLACs. A QLAC is a deferred fixed annuity with an annuitization date as late as your 85th birthday.
As a qualified annuity, you hold a QLAC in your IRA or qualified retirement account. You can buy a QLAC using assets in the account. You’re allowed to put up to 25 percent of all your IRA balances into a QLAC, and up to 25 percent of each non-IRA qualified account, capped at an overall maximum of $130,000 (as of 2019).
The remarkable thing about a QLAC is that it doesn’t have RMDs until you annuitize it. Furthermore, you exclude the QLAC’s value from the account’s RMD. The net effect is to delay RMDs on a portion of your retirement savings, so that more of your money will be available later in life.
Understanding RMDs for Beneficiaries
If an employee is the owner of a qualified annuity and was receiving periodic distributions before death, any remaining payments to the beneficiary must occur no less rapidly than they would to the owner.
If the qualified annuity owner has not yet started taking RMDs, the entire annuity balance must be distributed according to one of these rules:
- The balance must be distributed by Dec. 31 of the fifth year following the year in which the owner died.
- The balance must be distributed annually over the life expectancy of the beneficiary, starting no later than Dec. 31 of the year the employee’s death. However, a surviving spouse can wait to receive RMDs until Dec. 31 of the year in which the employee would have reached age 70 ½.
The employee plan determines which rule applies. The plan might allow the employee or beneficiary to decide, but the decision must be made before the earliest RMD under either of the rules. If no decision is made and the plan doesn’t specify which rule applies, then distributions must follow the second rule. If no beneficiary is designated, the first rule applies.