Tax Implications of an Immediate Annuity Bought With Roth Funds

Roth accounts provide savers a way of securing tax-free funds in their retirement. Contributions made to a Roth account aren’t tax deductible, but as long as certain criteria are met, distributions of growth come out tax-free. A taxpayer might use Roth funds to purchase an immediate annuity, which begins paying out a guaranteed payment stream right away. Making such a maneuver can have a variety of tax implications.

Qualified Distribution

The tax-free treatment of payments made from a Roth account only applies to qualified distributions. If a distribution doesn’t qualify, then any untaxed growth becomes taxable income and might be subject to an additional 10 percent penalty tax. Typically only withdrawals made after you turn 59 and a half qualify for the tax-free treatment. Some circumstances, such as following a death or disability, and uses, such as purchasing a first home, qualify for the preferential tax treatment. Additionally, the money you withdraw must have been in the Roth IRA for five tax years to qualify.

Purchasing the Annuity

Immediate annuities begin paying out right away, which precludes policy owners from making additional contributions. The amount you pay to fund an immediate annuity forms your tax basis. Even though you weren’t taxed on part of your qualified Roth distribution, you can still use tax basis rules to recover the purchase price from your annuity tax-free.

General Rule for Annuity Payments

Annuity contracts make periodic payments in exchange for an upfront payment. The amount of the payments is set to provide the annuity owner with a return on his investment. Because annuities typically pay out for the remainder of the annuitant’s life, tax laws require that annuitants recover the basis proportionally over their life expectancy. The exclusion ratio, which is calculated by dividing the tax basis by the anticipated payout calculated using IRS tables, provides a simple way for taxpayers to calculate what portion of each payment is tax-free. After the taxpayer recovers the entire basis, further payments become 100 percent taxable.

Inheritance Issues

Funding an immediate annuity from a Roth account can eliminate one of the major tax advantages the plans offer. When you die, the beneficiaries of your Roth accounts don’t have to pay income tax on the balance. Depending on the terms of your annuity, your survivors might not receive a cent. Some annuities offer provisions to continue payments to your spouse, or make a single payment refunding your account balance. If your heirs do receive a payout, they’ll have to pay tax on any growth above your remaining tax basis.