Some things in this world complement each other so well that they will always be considered classic combinations. If given the choice, most people would take ice cream with their cake and would enjoy cheese with their glass of wine.
However, some great combinations come from pairings you might not expect. Who would have thought that salt could taste good with caramel or a slice of cheese could accompany apple pie?
Now that your mouth is watering, let’s shift to a healthier topic: financial planning. Specifically, let’s explore the seemingly strange yet powerful combination of an annuity inside a Roth IRA.
Here is my first warning to clients who are looking at an annuity: Anybody who tells you annuities are the best investment is wrong, and anybody who tells you annuities are the worst investment is wrong. Just as with every other place clients can put their money, annuities have advantages as well as disadvantages. However, many of the negative aspects of an annuity can be eliminated by funding it with Roth assets, and the benefits of an annuity can complement the tax advantages associated with a Roth.
In our practice, we have learned that clients don’t complain about the downsides of an investment; they complain about the downsides they didn’t know about. So first we need to explore two of the main drawbacks of putting money in an annuity contract: taxes and liquidity.
Downsides of Annuities
Let’s start out by looking at the taxation of annuities. In most other investments, the growth in the account is taxed at long-term capital gains rates if that investment is held for more than 12 months before selling it.
In an annuity, the growth will be taxed at ordinary income tax rates, regardless of how long your client holds the annuity before taking their money out. This is one of the disadvantages of annuity products, since long-term capital gains rates are much lower than ordinary income tax rates for the same individual or family.
However, this disadvantage can be avoided by using Roth accounts to fund the annuity. Since the account registration supersedes the tax rules of the annuity, all the growth in an annuity funded with Roth money potentially will be tax-free (as long as the rules for qualified distributions are followed). Many annuities can provide investors with decent returns, considering the low risk of principal. So being able to take advantage of this type of risk-adjusted return in a tax-free setting makes it very appealing to clients.
The next big downside of an annuity is the lack of liquidity. In most annuities, there are surrender periods between three and 10 years long. Potentially high penalties can result if a client liquidates the annuity within that surrender period.
But in a Roth IRA, investors will want to wait at least five years from when it was initially established or until age 59½ (whichever comes later) to make sure the distributions are qualified and thus tax-free. In addition, most people who put money into a Roth will wait even longer before they start accessing that money. This is because investors want to get tax-free growth on the asset for as long as possible, and the true tax advantage comes from taking the money out in the distant future (when tax rates potentially will be much higher).
Since most people will avoid liquidating their Roth accounts in order to maximize the tax-free growth, the surrender periods on annuities are seemingly less restrictive if they are funded with Roth dollars.
Benefits of Annuity/Roth Combo
As you can see, two of the biggest pitfalls of annuities are of much less concern if the annuity is used inside a Roth. On top of that relief, many of the benefits of an annuity contract can be enhanced by using it within a Roth account. Let’s take a look at how three of the main advantages of using an annuity can be made even better by using Roth assets: lifetime income, protection of principal and contract bonuses.
One of the main reasons clients consider using an annuity in their financial plan is the fact that it is one of the few items that will provide guaranteed income for life. With medical advances and the enhanced risk of retirees outliving their money, the lifetime income benefits of annuities have become increasingly attractive. And most insurance companies will offer higher guarantees or potential returns on the income benefit of the contract to incentivize people to use the lifetime income features.
This unique benefit is made exponentially better if the lifetime income is tax-free, which can be done if the annuity is funded with a Roth. The only thing better than getting income guaranteed for the rest of your life is getting that income without having to pay any taxes on it, although taxes are due with a Roth conversion or any contributions to the account.
Another positive feature that can be found in many annuities is protection of principal. In a fixed annuity, the client cannot lose money due to market performance. This risk management strategy can be particularly attractive in a Roth because the only thing worse than losing money is losing money that could have been distributed tax-free. In addition, there are no tax advantages associated with taking market risk in a Roth, because losses in a Roth account cannot be written off or carried forward.
The last benefit of an annuity that pairs well with a Roth is the contract bonus. Many insurance companies will offer annuity products that have an upfront bonus. This feature can be very impactful inside a Roth account, as it can help mitigate or washout the taxes that were paid on a Roth conversion or the deduction that was missed on a Roth contribution.
In some cases, we have seen the bonus on an annuity contract completely offset the taxes paid on a Roth conversion, which helps people get over the emotional hurdle of paying taxes today to avoid taxes down the road.
It’s always surprising when a client has not considered an annuity in their portfolio or a Roth strategy in their financial plan. But it’s even more shocking when a client has both an annuity and a Roth and never considered the effect of combining these strategies. Although a Roth annuity might not be right for every portfolio, it should be analyzed and considered by almost everyone.
Ali Hashemian, CFP, MBA, is president of the Kinetic Agency, Los Angeles. Ali may be contacted at [email protected].