Executive Summary
Similar to retirement accounts like IRAs and 401(k)s, Congress provides deferred annuities a tax preference, in the form of tax-deferred growth, to encourage their use. This tax treatment does not have any outright cost; instead, it’s simply a benefit that is otherwise granted to the owner of an annuity. Yet because of the similarities in tax treatment between retirement accounts and annuities – and the fact that for much of their history, deferred annuities really were used primarily or solely for their tax deferral treatment – there is a long-standing rule of thumb for how to coordinate between the two: similar to muni bonds in an IRA, the rule is “never purchase an annuity inside of an IRA, because you don’t need tax deferral in an already tax-deferred account!”
Yet the reality is that for more than a decade, this rule has actually been rendered moot by significant changes that have occurred in the annuity landscape. While once upon a time there were few reasons to purchase a deferred annuity besides the preferential tax-deferral treatment, since the early 2000s annuities has been increasingly popular for their guaranteed living benefit riders, along with enhanced death benefit, unique investment features (in the case of certain equity-indexed annuities), or outright superior fixed income yields (with some fixed annuities). As a result, by 2012 the majority of annuities were actually being purchased with funds sourced from a retirement account, because that’s where the available money was held to be invested for such features and guarantees!
While in some limited cases, deferred variable annuities actually are making a resurgence for pure tax deferral purposes – in which case, there’s once again little reason to purchase them with retirement assets – most annuities continue to be purchased for their guarantees and investment characteristics, not their tax preferences. Given these changes, it is perhaps time to abolish the “annuities should never go into an IRA” rule and recognize that it has become more a myth and remnant of old than proper advice in today’s environment.
IRC Section 72 Tax Code Preferences For Annuities
Section 72 of the Internal Revenue Code provides a series of tax preferences for annuity contracts, broken into two broad categories: amounts received as an annuity, and amounts not received as an annuity.
The former refers to contracts which have actually been annuitized – i.e., converted to a stream of income, payable either for life, for a certain period of time, or a combination of the two (life with period certain). A payment from an annuitized contract is “an amount received as an annuity” under the tax code.
By contrast, the other category refers to withdrawals from contracts that have not actually been annuitized – i.e., from a “deferred” annuity. Notably, in the context of the tax code, the “deferred” label refers not to tax deferral treatment for the contract, but simply to the fact that the annuity starting date – the point at which the contract will be annuitized and converted into a stream of payments – has been deferred to some point in the future. In other words, from the tax code’s perspective, there are basically two types of annuities: those that have been annuitized, and those that haven’t been annuitized yet.
Because of their historical role in supporting retirement income – as a replacement for, or supplement to, other fixed lifetime income streams like pensions and Social Security – Congress decided early on to grant annuities certain tax preferences to incentivize their use. Annuitized contracts are eligible for the “exclusion ratio” treatment, where each payment is deemed to be a partial share of principal and interest (regardless of the actual growth on the underlying principal). And deferred contracts are allowed to defer taxation on any increases in value, with no income reported for tax purposes until either withdrawn (where distributions are deemed to be from gains first) or until annuitized (at which point the annuitization exclusion ratio rules kick in). In other words, annuities whose annuitization date is deferred to some point in the future are also granted tax-deferral treatment while still in the accumulation phase.
Notably, because the tax preferences for deferred annuities are simply granted as an incentive to encourage their use, there is no direct cost to tax deferral. Similar to purchasing a stock – which also enjoys the benefit of tax-deferred growth until it is liquidated – the tax benefits are simply a by-product of otherwise purchasing the investment, which in the case of an annuity may incur whatever costs are inherent in the annuity contract itself for its various features and benefits but are not actually an expense of tax deferral itself.
Origins Of The “You Don’t Need A Tax-Deferred Annuity In A Tax-Deferred Retirement Account” Rule
For much of the past century, annuities really were as the tax code “envisioned” – annuitized contracts provided lifetime income, and deferred annuities were simply accumulation vehicles for future annuitization that received tax deferral as a tax incentive for their use.
With the booming markets of the 1980s and 1990s, though, the focus began to shift. Variable annuities became increasingly popular as a pure investment vehicle, and the associated tax-deferral features of deferred variable annuities became appealing as a means to accumulate that equities-based growth in wealth on a tax-deferred basis – so much, in fact, that deferred annuities started to be created with an annuity starting date that was further and further out into the future just to ensure they could be used solely for accumulation purposes. In other words, the goal was specifically to create contracts that would likely never have to be annuitized at all, and could simply be retained in deferred mode for most of the individual’s lifetime (notably, some required annuitization endpoint was still required to be deemed an annuity in the first place, but companies increasingly began to offer maximum annuitization dates of age 90, 95, and beyond just to reduce the risk that it would ever actually be necessary to do so!).
In this heyday of deferred annuities as a tax-deferred vehicle to compound wealth, the saying/rule-of-thumb first emerged warning consumers “you don’t need to put a tax-deferred [annuity] inside of a retirement account.” After all, similar to the irrelevance of buying tax-exempt municipal bonds inside of an already-tax-deferred IRA, the purpose of so many of the deferred annuities at the time was tax deferral, and retirement accounts were already tax deferred. So if there wasn’t otherwise any purpose to the deferred annuity – especially in the case of a variable annuity, with subaccount investment options that could likely be replicated directly with a mutual fund holding similar investments but without the cost of the annuity – there was simply no reason to buy an annuity inside of a retirement account, especially given what were often 1% - 1.5% of additional annual annuity expenses.
New Breeds Of Annuity Guarantees And “The No-Annuities-In-IRAs” Rule Becomes A Myth
In the late 1990s, a new breed of variable annuity began to emerge: contracts with so-called “guaranteed living benefit” (GLB) riders. Unlike predecessor contracts that typically just included a (usually return-of-premium) death benefit, the idea of a living benefit was, as the name implied, a guarantee that could be used while the annuity owner was still alive. In other words, these riders were about providing income guarantees, while still alive, and without annuitizing up front; the first were called Guaranteed Minimum Income Benefit (GMIB) riders, and later came the Guaranteed Minimum Withdrawal Benefit (GMWB) riders as well.
The important distinction of this new breed of variable annuities was that many consumers began to buy the annuities not merely for their tax deferral features, but specifically for the retirement income guarantees they offered. The guarantees might either provide for current guaranteed income, or to secure a guaranteed base of income that would be available to tap in the future as the (baby boomer) accumulator approached retirement. And once variable annuities were primarily about purchasing guaranteed income – for much of the decade, more than 85% of all variable annuities purchased had a guaranteed living benefit (GLB) rider attached! – then they were purchased wherever the available dollars were to invest, which included retirement accounts. In other words, if your money was in an IRA and you wanted guaranteed income without annuitizing, the only option was to put those IRA funds into a variable annuity. Suddenly, it was entirely relevant and appropriate to put an annuity – at least a variable one with income rider guarantees – into a retirement account, because the purchase had nothing to do with tax deferral at all. It was about buying guarantees for retirement assets.
At the same time, the market turmoil of the 2000s also led to a dramatic increase in the purchase of equity-indexed annuities, which also provided unique guarantees – in their case, it was not necessarily about retirement income, but the potential to have some market upside while limiting the downside, which was especially appealing in the aftermath of the tech crash (and the financial crisis half a decade later). These contracts – similar to their variable-annuity-with-guarantees brethren – also became increasingly popular to own in a retirement account, for a similar reason: if the goal was to attach certain annuity-based guarantees to the assets, and those assets happened to be in a retirement account, then the retirement funds were used to purchase an annuity. Once again, it had nothing to do with tax deferral, and everything to do with buying (investment or income) guarantees for the assets.
In fact, in the aftermath of the tech crash, even certain fixed annuities became popular in retirement accounts as well, for their own form of ‘guarantees’ – in this case, the potential to receive a guaranteed CD-like fixed return, with a yield that was better than comparable bonds or CDs as the Federal Funds rate dipped as low as 1% in the early 2000s. And once again, if the fixed annuity return was better than available investment alternatives, and the investment dollars were held inside a retirement account… then the annuity was purchased inside the retirement account for investment purposes, regardless of the irrelevant tax preference.
The bottom line: the decade of the 2000s witnessed the simultaneous shift of variable annuities, equity-indexed annuities, and even some fixed annuities, to begin to be purchased within retirement accounts for reasons that had everything to do with their investment and income guarantees, and nothing to do with the ancillary tax deferral benefits that Congress had deigned on deferred annuities. And just because the tax deferral feature wasn’t necessary didn’t make it bad to own an annuity inside a retirement account, any more than it would be improper to own a stock inside a retirement account (given that it, too, is tax-deferred until liquidated!). Instead, the reality for both the annuity and the stock was that they’re purchased (inside a retirement account) for other reasons; in the case of the annuity, it’s because of the various guarantees and features that had become available, and accordingly it was entirely logical and appropriate for annuities to be purchased within retirement accounts, notwithstanding the implicit redundancy of the preferential tax treatment!
In fact, it appears consumers were already figuring out the irrelevance of the “don’t buy annuities inside of retirement accounts” rule all by themselves; according to LIMRA, by 2012 more than 60% of deferred variable and equity-indexed annuity purchases were being funded with IRA dollars!
Annuities In IRAs and 401(k)s In Today’s Environment
In recent years, shifts in the variable annuity marketplace have made guaranteed living benefit riders somewhat less appealing, and as a result their use with variable annuities has slowed a bit. Nonetheless, the overall election rate for guaranteed living benefit riders still remains fairly high at almost 80%, which leaves variable annuities relevant as a potential ‘investment’ for IRA and other retirement dollars.
Similarly, the emergence of guaranteed living benefit riders on equity-indexed annuities has arguably made them even more popular as a potential fit within retirement accounts, both for the risk/return characteristics of the annuity as an investment and the guaranteed income features for retirement spending (assuming the contract is otherwise desirable as an investment in the first place, which is an important caveat!). And even fixed annuities have seen a recent uptick of retirement accounts as a source of funds as retirees struggle to find investments in retirement accounts with compelling yields!
At the same time, though, it’s important to recognize that the onset of new top tax rates for capital gains, qualified dividends, and ordinary income – on top of a new 3.8% Medicare surtax on investment income – has made variable annuities a bit more popular once again as a pure tax deferral vehicle, especially given the latest breed of ultra-low-cost annuity wrappers that really do make it possible for the raw tax deferral benefit to exceed the annual annuity cost! In other words, there actually is a fresh case to be made for incurring the cost of deferred annuities just to gain access to a tax deferral vehicle, especially to wrap around especially tax-inefficient investments as a part of an overall asset location strategy for higher net worth clients. And in such circumstances, it makes no sense to use already-tax-deferred retirement account assets to fund the strategy, giving credence once again to the old rule of thumb.
Nonetheless, the reality – as evidenced by the incredibly high election rate for buyers of annuities with guaranteed living benefit riders, and the rise of equity-indexed annuities as well – is that the majority of annuity purchases are still about buying access to guarantees (whether for retirement income, or a version of today’s enhanced death benefit riders as well), and/or to unique investment opportunities (e.g., the risk/return profile of an equity-indexed annuity, or a compelling yield in a fixed annuity). As a result, while a few high-net-worth investors may once again be using annuities primarily for tax deferral alone, in most cases in today’s environment the “don’t buy an annuity inside a retirement account” rule has become more of a myth than proper advice!
