Rules for Rolling Your IRA or 401(k) Into an Annuity

How Does an IRA or 401(k) Into an Annuity Rollover Work?

Rolling an individual retirement account (IRA) or a 401(k) plan into an annuity is a simple process, and it can be done without incurring any taxes or penalties, as long as it’s handled in an IRS compliant way. Essentially, there are two ways to execute a rollover — directly through a transfer or indirectly through a qualifying withdrawal.

As its name implies, a direct transfer is a more straightforward approach. It’s handled almost completely by the financial institutions managing your money. Completing some forms and providing your authorization is the extent of your involvement.

With a qualifying withdrawal, you take possession of the liquidated retirement funds (in some cases, net of an automatic 20% IRS withholding). Then, to avoid tax complications, you must put the gross amount of the withdrawal into an annuity within 60 days of receipt. Finally, you can recover any funds withheld by the IRS when filing your taxes.

Why Would You Roll Over an IRA or 401(k) into an Annuity?

There are a variety of reasons you may look to roll an IRA or 401(k) into an annuity, all of which relate to enhancing your retirement plan. Given the limited benefit provided by Social Security and the cessation of defined benefit pension plans for most workers, this has become an increasingly important objective for many Americans.

Those who utilize annuities to optimize their retirement plans enjoy a variety of benefits.

Benefits of a Rollover

Achieve a Guaranteed Stream of Income

The primary reason you may want to execute a rollover is to achieve a guaranteed stream of income. You can use a retirement account to generate income but doing so entails holding assets that exhibit volatility — oftentimes, a significant amount of it. With an annuity, you eliminate the risk, earning a predictable return with downside protection.

Mitigate Longevity Risk

The possibility of outliving your savings is another key motivation for rolling money into an annuity. Annuity payments can be structured to last your entire life or, if you are married, for two lifetimes. You cannot do this with stocks and bonds.

Extend Your Tax Deferral Benefit

This is another benefit of some annuity rollovers. If you keep your money in a traditional retirement account, you must take a taxable required minimum distribution (RMD) each year, beginning at the age 73. Failure to do so will result in a penalty of 50% of the required RMD.

Qualified annuities are exempt from the RMD rules. With a qualified annuity, you can defer receiving income payments until age 85. This may enable you to avoid getting bumped into a higher tax bracket, and it could lower your Medicare premiums. The extended deferral can be especially effective if you end up working into your later years.

Customize the Structure of Your Investment

Oftentimes, this entails establishing a joint life structure that provides a payment throughout the lives of you and your spouse. In some cases, it entails adding a death benefit rider and/or a cost-of-living adjustment rider.

Caroline was faced with a key decision to make: how to allocate her retirement accounts to ensure she will have enough to provide for her family after her retirement. She was in her late 40s, with a 20-year career as an elementary arts teacher, and had low risk tolerance and just her 403(b) provided by the school. After doing her financial plan and carefully updating her cash flow for her later years, we found a gap that needed to be filled. Given her expectations and low profile, she decided a comfortable alternative would be to supplement her investment portfolio, retirement accounts, and Social Security with an annuity that will provide for the inflation and gap her retirement projections required.

Elaine King, MBA, CFP®, CDFA™, CFBA, ACCFounder of Family and Money Matters™

Elaine King, CFP®, founder of Family and Money Matters™, empowers families’ financial and human capital for wellbeing. She’s crafted actionable plans for 1,200+ families and 100+ enterprises. A recognized financial education advocate, creator of LATAM’s first family financial program and winner of the Best Latin Book Award. Featured in top publications and honored by Investopedia and People Magazine.

Risks of Rolling Over Your IRA or 401(k) into an Annuity

As with any financial instrument, the benefits of rolling money into an annuity must be carefully weighed against the risks. An annuity can be a sound investment choice for someone who is overwhelmed by investing and concerned about longevity risk. However, it makes little sense for a hands-on investor that is unlikely to outlive their savings.

Risks of a Rollover

Complexity

Annuities are complex, and their terms and provisions can be confusing to the average person. This may be problematic, especially if unethical salespeople push these products without explaining how annuities work or considering the unique needs of potential buyers.

Low Yielding

Annuities offer investors guaranteed income, but their returns are much lower than many of the financial securities and fund-style vehicles you can hold within retirement plans. Before rolling money into an annuity, make sure you clearly understand the trade-off.

Illiquidity

Annuities are less liquid than retirement plans. Once you reach retirement age, you can withdraw your 401(k) or IRA savings at any time. However, with an annuity, your monthly income distributions are fixed per the terms of the agreement.

High Fees

Generally, annuities are more costly than retirement accounts. Buying an annuity entails a commission. Then, you will incur ongoing mortality and expense risk charges, administrative fees and fund management fees associated with your investment selections. Collectively, the ongoing fees can easily amount to 3% to 4% per year.

Steps to Rolling Your IRA or 401(k) to an Annuity

Whether you are looking to roll over an IRA or a 401(k) into an annuity, there are some standard steps you should follow.

4 Steps to an Annuity Rollover

1. Consult with a financial advisor and have an in-depth conversation about annuity rollovers in the context of your unique circumstances.
2. If you opt to proceed, shop around for the optimal annuity. Be sure to assess the financial strength of the issuing insurance company.
3. Contact the preferred insurance company and communicate your intentions (or have your financial advisor do so).
4. Finally, the insurance company should try to make your rollover experience as smooth as possible. You will need to complete some forms and provide your authorization for the transaction.

The rollover process is simple, as long as you execute it through a direct transfer.

Best Practices and Strategies for Rolling Existing Retirement Funds into an Annuity

As you consider rolling your retirement savings into an annuity, make sure you are familiar with the various types of annuities. At the highest level, they can be categorized into the following three categories.

3 Types of Annuities

Fixed Annuities

This type offers a guaranteed rate of interest for a set period, which could be your lifetime. They are extremely safe and have highly predictable income streams.

Fixed Index Annuities

This type offers investors higher return potential than fixed annuities because they credit interest based on a market index, such as the S&P 500. They do not participate directly in the stock market, but they offer annuitants upside potential and downside protection.

Variable Annuities

Variable annuities offer higher return potential than fixed index annuities, but they are exposed to downside risk. These vehicles are comprised of a portfolio of underlying investments, and they can exhibit a high degree of volatility.

Variable and fixed index annuities are not ideal for a rollover strategy. In fact, they are not usually permitted for qualified rollovers. Fixed annuities, on the other hand, are permitted for any type of rollover, and they offer the exact things rollover initiators seek — guaranteed income and the opportunity to eliminate longevity risk.

Annuity Strategies

Beyond understanding the different characteristics of an annuity, there are a couple strategies you should know about. The first is annuity laddering, an approach that involves buying a handful of relatively small annuities over several years, rather than rolling over all the money into a single annuity.

It is an effective way to mitigate interest-rate risk, and it makes sense if you think interest rates will rise. Staggering your purchases over time prevents you from getting locked into a single fixed rate and missing out on higher income in later years.

Another prominent strategy is to delay receiving your annuity payments as long as possible. Since your life expectancy is part of the calculation that an annuity provider uses to determine the size of your monthly payments, a shorter life expectancy results in higher payments. The older you are when you begin receiving payments, the more you will receive each month.

How Much Should You Roll Over From Your IRA or 401(k) to an Annuity?

Before you execute a rollover, a final thing to consider is how much of your retirement account to transfer. This starts with an analysis of your projected living expenses.

Conservative individuals should strive to generate a guaranteed monthly income stream that covers 100% of their expenses on an inflation-adjusted basis. Usually, the sources of such income are Social Security and pension plans from former employers. Unfortunately, the combined cash flow is not always sufficient.

However, by rolling over an IRA or 401(k) into an annuity, the shortfall can often be addressed. Rolling over an entire retirement account is possible, but a complete liquidation is not always advisable. You may benefit more by only rolling over just enough to close your projected income gap. Doing so will allow you to hold onto some relatively high-returning assets, while stabilizing your cash flows.

If necessary, a financial advisor can help you project your income streams, assess your annuity options and determine which strategies are best for you. Connect with a vetted professional using the advisor match tool.

What Are the Tax Rules and Implications for Rolling Over an IRA or 401(k) Into an Annuity?

The rules for rolling over a retirement account into an annuity are simple, but vary based on the type of account. If handled improperly, a rollover can cause serious tax ramifications.

Traditional IRA and 401(k)

Traditional IRAs and 401(k) plans are tax-deferred retirement accounts. This means, you don’t pay income tax on the funds you contribute. Rather, you pay tax on the money withdrawn during retirement.

Typically, there are no tax implications for moving money from your traditional IRA or 401(k) plan into an annuity. The easiest way to do this is to make a direct rollover from your retirement account into a qualified annuity. The insurance company issuing the annuity will facilitate the transfer.

Roth IRA and Roth 401(k)

Roth IRAs and Roth 401(k) plans are after-tax retirement accounts. This means, the funds you contribute are fully taxable and do not produce any tax deductions. However, qualifying withdrawals of both the principal and any accumulated earnings are completely tax-exempt.

If you roll over money from a Roth-style retirement account into a Roth annuity, the annuity retains the tax-exempt status — as long as you follow the rollover rules. A direct transfer is the easiest way to execute a rollover.

Direct and Indirect Rollovers

As noted previously, there are two ways to execute a rollover: directly through a transfer or indirectly through a qualifying withdrawal.

A direct rollover occurs when you transfer funds directly from a retirement account into an annuity. Direct transfers, which have no tax ramifications, are commonly executed through a wire transfer from the liquidating retirement plan provider to the annuity issuing company.

In some cases, the retirement plan provider may mail a check, payable to the annuity issuer, to you for handling. This still counts as a tax-free, direct transfer.

An indirect rollover is more complicated than a direct rollover, and it exposes you to a greater probability of incurring unwanted tax consequences. With a qualifying withdrawal, you take possession of the liquidated retirement funds, which are automatically reduced by a federal withholding of 20%. for qualified retirement plan distributions.

Then, to avoid taxes and penalties, the gross amount of the retirement account liquidation must be rolled into an annuity within 60 days of distribution. The IRS only allows for one 60-day rollover every 12 months. If you don’t adhere to the 60-day limit, it will result in severe financial ramifications.

Does It Make Sense to Roll Your IRA or 401(k) Into an Annuity?

Rolling over an IRA or 401(k) into an annuity can make a lot of sense for a person nearing retirement who worries about outliving their nest egg and has a minimal tolerance for asset risk. While relatively low-yielding, annuities provide a guaranteed, lifetime stream of income that exhibits zero volatility.

That said, an annuity rollover is a suboptimal move for a growth-minded investor who has a long horizon, wherewithal to endure near-term market volatility and ability to generate income from other types of investments. If you are this type of person, consider keeping your savings in a diversified retirement account.

Frequently Asked Questions About Annuity Rollovers