A Lifetime Stream of Tax-Free Income
An annuity within a Roth IRA offers guaranteed payments without the tax tab.
EDITOR'S NOTE: This article was originally published in the April 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.
A drawback of most annuities is the steady tax bill that comes with that steady income stream. But there is a way to get guaranteed payments for life without the tax tab: investing in an annuity inside your Roth IRA.
Although it is generally frowned upon to put a tax-deferred annuity inside an IRA tax shelter, in some circumstances it can make sense for a portion of an investor's assets.
Brian Kunkel, national director of advanced planning and solutions for Prudential Annuities, notes that deferred variable annuities with guaranteed income streams are increasingly popular with investors who have been burned by stock market volatility.
With a variable annuity, you invest money in mutual fund-like subaccounts and allow the investment to grow before beginning to take income. Some plans base lifetime payouts on the highest level a portfolio achieves, even if market losses diminish the value before payments begin.
When the annuity is inside a Roth, once you annuitize to start the stream of lifetime payments, all payouts in retirement can be tax-free. "The annuity doesn't change any Roth IRA rules," says Kunkel. That means payouts are tax-free until you have recovered all your contributions to your Roth, and earnings are tax-free, too, if you're at least 59 1/2 and the account has been opened for at least five years.
An annuity is a long-term investment vehicle, and the earlier you place money into a Roth IRA, the longer tax-free growth can compound, says Kunkel. You can contribute up to $5,000 a year ($6,000 if you are 50 or older) to a Roth and those funds, plus any amount you have converted from a traditional IRA, can be invested in an annuity. You can also place an immediate annuity in a Roth.
If you already hold an annuity in a traditional IRA, you can convert it to a Roth. Of course, that would require paying tax on the value of the investment, and valuing a deferred annuity can be tricky. If you go this route, pay the tax on the conversion with money held outside the IRA to avoid diluting your nest egg.