Roth Annuity Purchase is a Lifetime Stream of Tax-Free Income

Annuities are investment contracts insurance companies sell that agree in exchange for an original investment by the purchaser, the insurance company will make periodic payments to the investor at a later time such as retirement.  One drawback to purchasing an annuity is the fact that taxes need to be paid when the money is withdrawn which can cost thousands of dollars paid to the Federal government annually.  

Annuities can be purchased as a stand-alone, non-qualified investment but don’t allow for tax-free growth, only a tax-deferred growth which means taxes must be paid when withdrawn.  However, there is a way to guarantee that income during retirement is tax-free for a retiree and their family—Roth IRAs.

Many financial advisors believe that when deciding what type of retirement assets to purchase, the best use of funds is to purchase a Roth IRA.  This is in part due to the payment of taxes before funds are invested, leaving the investment dollars to grow over time, then withdrawing the funds tax-free during retirement.

Some experts frown upon putting a tax-deferred annuity inside a retirement IRA, but in some cases, it can make sense for a percentage of an investor’s assets to be in a Roth annuity.  For those who have lost money with a volatile stock market during the first decade of the millennium, a guaranteed income stream, such as one found in a Roth annuity, is becoming increasingly popular.

Conversion to a Roth Annuity

For those who are interested in having tax-free income during retirement, take 401(k), 403(b), or IRA assets, pay the current taxes, then transfer the funds to a Roth account.  Once they have completed the transfer, purchase a fixed indexed annuity in order to reduce risk.  A fixed indexed annuity locks in function on gains with no risk of market volatility.  There are a few factors that should be considered before using this strategy, such as:

  • Age
  • Time of retirement
  • Income needed

Timing is Everything

If funds are needed for 10 years, then other routes should also be considered.  As a good rule of thumb, if the need for qualified funds is 10 years or greater than a Roth conversion is an absolute winning strategy.  Whether the funds are used for an annuity or other investment structure, recovering the taxes paid at conversion is considerably less than the growth of the Roth IRA or Roth annuity over time.

Once an annuity is inside a Roth, when the income payments begin, they are received as tax-free.  Payouts from the Roth annuity are tax-free, along with earnings, if a person is at least 59 ½ and the account is at least 5 years old.  So, these types of investments need to be purchased 5 years before retirement.

Investing in a Roth Annuity

Some variable annuity plans base lifetime payouts on the highest level the portfolio achieves.  This is desirable to many because, even if the value is diminished from market losses before payments begin, the payouts remain at the highest level eliminating most of the risk.

As a long-term retirement investment solution, the earlier an investor places money into a Roth IRA, the longer the investment can grow tax-free.  Contributions of up to $5,000 yearly for those under 50 and $6,000 for those over 50 make catching up on lean years available.  If an investor has a traditional IRA, those funds can also be invested in an annuity.  An immediate annuity can also be placed in a Roth.

For investors who already have a traditional IRA, depending on their particular situation, conversion to a Roth IRA with a deferred annuity can be a money saver.  Pay special attention to the tax that will need to be paid when transferring the funds and the amount of time left before retirement.  A financial advisor would be able to determine the best time to transfer these funds and if the cost is worth the conversion.

Non-Qualified Annuities

If non-qualified annuities are purchased with after-tax money, just like a Roth IRA, then why would an investor even consider a non-qualified annuity as an option?  Limitations.  Contributions to Roth IRAs are subject to limits based on income and this yearly dollar amount may not be the maximum that an investor wants to put into an account.  There are particular situations where a non-qualified annuity is appropriate, but for the average working American, a Roth IRA tends to be the better option.

Roth IRAs

As an investment option, a Roth IRA has many desirable traits.  First, a Roth IRA is a tax-qualified plan and can be funded using many different types of accounts including annuities.  Roth IRAs are desirable to many because the money invested grows tax-free and is not taxed when the money is withdrawn on a qualified distribution.  Qualified distributions are not only withdrawals from the initial investor, but for any beneficiary for the plan.  This means that loved ones don’t have to worry about paying taxes on this income.

Avoiding Penalties

Often, investors come to financial advisors with only one type of retirement plan in their portfolio—a 401(k).  One problem with 401(k) retirement plans is that once a person leaves that particular company, there is no longer an employer match.  Another problem is that any money drawn from the 401(k) is subject to taxes.  Hefty penalties can also be assessed for early withdrawal.  However, there is a way to avoid these costly penalties.

Conversion from one qualified plan to another can keep these penalties at bay.  Switching from a 401(k)-retirement plan to a Roth IRA can save an investor and their family thousands of dollars over the course of a working lifetime.  For example, if a young college graduate starts out at a company that allows a 401(k)-retirement plan with an employer match, he should definitely take that option.  Free money for investment is always wise to choose.  

Fast forward ten years where this worker now leaves this company and takes employment with another company that offers a 401(k).  If he leaves this money at the other employer, not only will he be losing the employer match, but he will probably also be paying management fees and other costs that can eat away at his nest egg.

If this worker converts this 401(k) to a Roth IRA, he will still have to pay the taxes on the money, but he will not incur the hefty 10 percent tax penalty for early withdrawal.  In addition, this money now can grow tax-free until retirement.  A nice way to enter retirement is with tax-free income.  

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