8 reasons fixed-income annuities belong in your IRA

Published: May 12, 2014 5:00 a.m. ET





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In addition to understanding the details of a potential investment and how it will meet your needs, there are occasions when you need to decide where it will be held.

Will your investment reside in a nonretirement or retirement account? There are different income-tax consequences that can affect the longevity of a particular investment as well as your overall portfolio depending upon where it's held.

While there are income tax deductions available for making contributions to retirement, or "qualified," accounts, these types of accounts are generally not as tax-friendly as nonretirement accounts when taking withdrawals from them. The potential unfavorable income-tax consequences include (a) full taxation of withdrawals with potential exclusion for nondeductible contributions and Roth IRA distributions and (b) compliance with IRS' required minimum distribution, or RMD, rules.

Having said this, if you own a traditional IRA, there's an investment that's often overlooked that can be a natural fit in the right circumstances. It's called a fixed-income annuity.

What is a fixed-income annuity?

A fixed-income annuity is a fixed (as opposed to variable) annuity that provides either a lifetime payout or payments over a contractually-defined term. The payments are a fixed amount unless an inflation factor is added.

There are two basic types of fixed income annuities that are distinguished by the timing of their initial payments: immediate and deferred.

Immediate annuities are purchased with a lump sum, or single premium, and thus are referred to as single premium immediate annuities, or "SPIA's." Payments begin one month after the purchase date when a monthly payout option is elected, with quarterly and annual payouts available.

The start date for deferred fixed-income annuity payments is at least one year after the date of purchase and is typically much longer. Single premium deferred annuities ("SPDA's") are purchased with a lump sum while flexible premium-deferred annuities (FPDAs) allow multiple purchases.

Two types of deferred fixed-income annuities

There are two types of commercially-available deferred fixed-income annuities: (a) deferred-income annuity, or DIA, and (b) fixed-index annuity, or FIA, with an income rider. Both offer sustainable lifetime income, the payment amount of which is either known or can be calculated at the time of investment, depending upon the type of fixed-income annuity, with taxation deferred until payments are received.

There are four basic differences between a DIA and a FIA with an income rider:

  • The income start date is contractually defined with a DIA and is flexible with an FIA, with the exception of the earliest start date, which is contractually defined and is typically age 50 and one year of ownership.
  • In addition to deferred income, there's an investment, or "accumulation," value with a FIA versus none with a DIA.
  • FIAs have a death benefit equal to the contract's accumulation value whereas this is generally optional with a DIA, and, when elected, is payable as a return of premium only in the event of death before the income start date.
  • Distributions from DIA's held in non-retirement accounts are tax-favored since a portion of each payment is nontaxable as a return of principal until 100% of one's original investment has been returned, while "last-in first-out," or LIFO, tax treatment applies to FIA income withdrawals with 100% of distributions taxable as ordinary income until all earnings have been received.

See: FIA's With Income Riders vs. DIA's: Which is Right for You?

Why can fixed income annuities work well in a traditional IRA?

When analyzing potential investments for inclusion in a traditional IRA, SPIA's, DIA's, and FIA's with income riders are all potentially suitable depending upon the individual IRA owner's financial situation, including tax bracket.

There are eight reasons why one or more fixed-income annuities can make sense for a portion of one's traditional IRA accounts:

1. Comply with required minimum distribution rules

The IRS requires you to take minimum distributions, RMDs, each year from your traditional IRA accounts beginning by April 1 of the year following the year that you turn 70-1/2. The amount of your annual distribution is calculated using the value of your traditional IRA accounts, excluding fixed-income annuities, as of Dec. 31 of the prior year and a life expectancy factor from an IRS table.

See: RMD: A sensible systematic withdrawal plan

The purpose of the life expectancy factor is to liquidate the IRA owner's account through annual distributions over the joint life expectancy of the IRA owner and his/her beneficiary. Fixed-income annuities generally comply with the IRS' RMD regulations provided that payments (a) are structured so that they will be completely distributed over the life expectancy of the owner and the owner's beneficiary, and (b) begin by April 1 of the year following the year that the owner turns 70-1/2.

2. Don't need to sell investments at inopportune times to comply with RMD rules

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