Funding a Roth IRA With a Variable Annuity
Tax Issue
Both IRAs offer an investor tax-deferred growth. Contributions to Roth IRAs are made on an after-tax basis. Distributions of these contributions are not taxed to the taxpayer or the beneficiary. Qualifying distributions of the gain in a Roth IRA are tax free to the Roth IRA owner or the beneficiaries. However, if no gain above the basis in a Roth IRA exists, there is no tax benefit to having a Roth IRA.
Because of stock market volatility and historic low interest rates on bonds and bank products, investors are looking for places to invest that will generate gain within the Roth IRAs. Therefore, investors seek an investment vehicle that can guarantee the tax benefit sought by having a Roth IRA.
Applicable Tax Law
- The gain on the sale of stock is taxable to the shareholder as a capital gain. The maximum capital gain rate is 15%.
- Loss from the sale of stock can be used to offset gains from the sale of other stocks or capital assets. Losses that exceed gains on other capital assets can offset ordinary income up to $3,000 each tax year. Unused capital losses may be carried forward to future tax years.
- Qualified dividends tor assets held more than 60 days are taxed at 0% for taxpayers who are subject to the 10% or 15% tax bracket and at 15% for taxpayers who are subject to higher tax brackets.
- Earnings on Roth IRAs are tax deferred.
- Qualified distributions from a Roth IRA are tax free.
- Death benefits from a Roth IRA are paid to the beneficiaries free from federal income tax if the 5-year period is met.
- Losses on Roth IRAs are not deductible unless the entire account balance of all Roth IRAs is distributed and the taxpayer has un-recovered basis left in Roth IRAs. The only way to deduct a loss on a Roth IRA is to distribute the money from all Roth IRA accounts. In this situation, it is then only deductible if the taxpayer itemizes deductions and the deduction itself is subject to 2% AGI limitation.
Tax Planning Strategies
One strategy for a Roth IRA investor is to use a variable annuity as the funding vehicle. By using the death benefits and living benefits of a variable annuity, an investor can guarantee growth in his or her account and guarantee a value above and beyond the basis of the Roth IRA to be paid to his or her beneficiary. With capital gains and qualified dividend tax rates being low, and investor might be better served using stocks as investments in non-retirement accounts.
Variable annuity. A variable annuity is a contract between an owner, or investor, and an insurance company. The terms of the contract offer the investor the ability to defer tax on earnings in the contract. When a variable annuity is used to fund a Roth IRA, the tax treatment of distributions follows the same rules as any other investment vehicle used for a Roth IRA.
A variable annuity allows the investor to select from variable subaccounts within the contract. These variable subaccounts act like mutual funds in that the subaccounts invest in markets according to the investment objective of each subaccount. The earnings or losses on these subaccounts are passed through to the investor in the form of an increase or decrease in the subaccount’s share, or unit, value. The management fees for the subaccounts are similar to mutual fund management fees and are reflected in the net unit value.
In addition, the contract can have additional benefits that are guaranteed by the insurance company. The additional benefits can take the form of death benefits or living benefits.
Death Benefit. Variable annuities generally have an automatic death benefit of the amount contributed to it. In recent years, variable annuities have added benefits to the contract in the form of riders. Some of these riders ratchet up the death benefit when certain events occur. One such rider automatically increases the death benefit by a certain percentage each year.
Another type of rider allows for the death benefit to be increased when the sum of the subaccount values increases. This rider allows the investor to lock in the gain on a contract on a specific date, usually the contract anniversary. Some contracts allow the lock into occur more frequently, even as frequently as on a daily basis. If the subaccount values decrease, the contract will generally have a minimum guaranteed amount, such as the amount contributed. Generally once a lock-in occurs, the new death benefit becomes the largest value of the initial investment, the current value, or the highest lock-in value.
Living benefits. A variable annuity’s account value, the amount an investor can access, is generally the subaccount values minus any applicable surrender charges. Because of market fluctuations in the subaccounts, it is quite possible the value of the annuity will be less than the amount invested. Insurance companies have created living benefits to offer guarantees to investors regardless of the subaccount performance. A couple of living benefit riders include guaranteed withdrawal benefits and guaranteed income benefits.
Guaranteed withdrawal rider. An annuity contract can guarantee to an investor an amount from which he or she can withdraw funds from. The guaranteed amount is generally based on a fixed return, such as 5%. The insurance company will keep a separate financial record keeping of the subaccount values from the guaranteed values. When the investor begins taking withdrawals, the withdrawal amounts will be based on the higher of the subaccount value or the guaranteed value. Some guaranteed withdrawal riders offer the investor opportunities to step up the guaranteed values if the subaccount values increase. In addition, the investor’s beneficiary may be able to keep the contract in form after the owner’s death, guaranteeing the beneficiary to receive the higher distribution amount.
Guaranteed income rider. Like a guaranteed withdrawal rider, a guaranteed income rider gives the investor the ability to take income from a guaranteed increased amount. The income amount can increase above the guaranteed amount if the rider allows for such an increase. Withdrawals taken from a guaranteed income rider generally come in the form of annuitization. With annuitization, the owner sells the contract back to the insurance company for a guaranteed stream of income. The guaranteed stream of income generally last for a specific time, either the investor’s lifetime, or a certain number of years. If the investor dies before the certain number of years occurs, the beneficiaries will receive the income. If the investor selects a lifetime income, there will be no income paid to any beneficiary upon the death of the investor. If the investor has not begun his or her guaranteed income stream by the time of his or her death, the contract can often pass to the beneficiary intact, thereby maintaining any guaranteed growth the contract has accumulated.
Costs of a variable annuity. A significant factor with death-benefit and living-benefit riders is that they generally guarantee an amount greater than the invested amount. An argument often heard against using a variable annuity to fund a Roth IRA is that variable annuities are cost prohibitive and the costs create a diminished return on the investment. Such costs include subaccount fees, expenses to guarantee death benefits and payouts, annual contract fees, and fees to guarantee living benefits. The costs are generally assessed against the investment values and not the guaranteed values. Therefore, the guaranteed amount is, in fact, the guaranteed amount. One perspective on the costs is that they are truly only assessed if the investment value outperforms the guaranteed amount.
Examples
Tax efficient investing. By allocating the investment vehicles properly, the tax risk of investments can be minimized. A gain inside a Roth IRA may not have produced a taxable gain had the investment occurred in a non-retirement account.
Tax losses. A loss in a Roth IRA is not deductible unless the entire Roth IRA values are distributed. Essentially, a loss in a Roth IRA defeats the purpose of having a Roth IRA. Investors should consider the impact of such gains and losses before using certain investments within a Roth IRA.
Death benefits. Proceeds paid to a beneficiary from a Roth IRA are tax free to the beneficiary. Because of this, the variable annuity offers a way to enhance the value paid out to beneficiaries.
Living benefits. By using a living benefit, an investor can guarantee growth on the variable annuity regardless of the investment performance.
Variable annuity costs. Many of the variable annuity costs are experiences only if the account value exceeds the guaranteed value.
Possible Risks
Beneficiaries may not always be able to access the guaranteed withdrawal benefits. Often a contract can pass from one spouse to another and maintain the same benefits. This is not necessarily true for other beneficiaries. The guaranteed withdarawal and/or guaranteed death benefit should be used strategically when choosing the benefits on a variable annuity contract. For example, a taxpayer without a spouse may place more important on the death benefit provisions knowing that the beneficiary will receive more money than invested. A taxpayer with a spouse may put more importance on the living benefits knowing that the contract, and all the provisions, may be able to pass on to the spouse with the living benefits intact.
Some benefits on contracts, both living benefits and death benefits, cannot be removed from the contract once the contract is issued.
Costs of the variable annuity can reduce the account value and account performance. Costs include expenses for subaccounts, expenses to guarantee living benefits and death benefits, annual contract charges, and surrender or sales charges. Variable annuities are sold by prospectus only and the prospectus should be read carefully before investing.
Variable annuity base contracts and riders vary widely depending on the insurance company, riders selected, and even the state the investor lives in. Investors should shop wisely for the benefit that would best serve his or her needs.
The examples illustrated in this strategy are hypothetical. Only an annuity contract issues by an insurance company can offer guaranteed benefits.
The costs for the variable annuity will lessen the value of the annuity. During periods of positive market returns, specifically returns greater than the guarantee, a taxpayer may find themselves stuck paying a fee for a guarantee that is no longer desires. If they liquidate the variable annuity and transfer the Roth IRA to another investment vehicle, the fees pain in over the years will not have provided a benefit to the investor.
Once an investor has started the variable annuity for a Roth IRA, he or she is attached to it in order to continue the contractual guarantees. If an account value decreases, but the guaranteed value increases, the only way to access the guaranteed values is to follow the provisions of the contract. Often the guarantee provisions limit the amount that can be withdrawn annually without terminating some or all of the guaranteed benefits. The investor needs to have a withdrawal strategy in order to take advantage of the benefits of the variable annuity without destroying the living benefits provisions.
Many contract guaranteed-growth provisions change upon any withdrawal from the variable annuity. For example, a contract may provide for a guaranteed growth of 5% on the withdrawal benefit. Once a withdrawal is taken from the contract, the guaranteed growth on what remains of the guaranteed value may be reduced to 3%. Each annuity contract is different and should be read carefully and understood before using the contract as a Roth IRA funding vehicle.
The use of variable annuities for a Roth IRA, or any other account, is controversial in the investment world because of the high fees and commissions paid to insurance representatives who sell the contracts.
Roth IRA investors whose sole purpose is to pass tax-free growth to beneficiaries may find the variable annuity to be a good way to guarantee this goal. However, if the investor is in good health, he or she may be better off bypassing the Roth IRA and purchasing a life insurance contract instead. An insured in good health can buy a much larger amount of guarantee for his or her beneficiary than a Roth IRA funded by a variable annuity can provide. Generally, the death benefit on a life insurance policy is received by the beneficiary free from federal income tax.
If an insurance company becomes insolvent, some or all of the benefits of a variable annuity contract may be at risk. Insurance is regulated by the states and most states have reserve requirements that need to be met by each insurance company before the insurance company can do business in the state. The reserve requirements offer an assurance to the insurance commissioners that the insurance company can perform on the guarantees offered in their contracts. In addition, most states have guaranty associations that require the insurance companies to pay into. The purpose of the guaranty associations is to provide for the administration of an insurance company’s guaranteed benefits in the even the insurance company becomes insolvent. Most states include guaranteed benefits that are riders on variable annuity contracts. However, there is no guarantee provided for the underlying subaccounts as the investor bears the risk of the market fluctuation for these subaccounts. State guaranty associations limit the amount of protection for each investor. For example, one state may limit the guaranty association protection for an annuity at $100,000 per investor for a particular insurance company. If an investor has a contract with a $500,000 guarantee on it, the state guarantee association will not provide any guarantee for the additional $400,000 contractual guarantee.
Contracts with living-benefit and death-benefit riders can have clauses in them that allow the insurance company to charge more for the protections offered by the benefits. If market conditions change, an insurance company can charge more for the benefit purchased. While these clauses do not exist on every variable annuity contract, the contract should be read and understood thoroughly so the investor is aware of such provisions.
