Rules for Rolling Your IRA or 401(k) Into an Annuity

Say you’re interested in using your retirement funds to buy an annuity. Should you withdraw the funds from your retirement account, pay the taxes and then buy the annuity? Or can you just roll over the funds directly into the annuity, continuing to avoid taxes until you receive the income stream payments?

In most cases, the IRS allows qualified funds to be transferred into, or out of, qualified annuities. So, it’s important to know the annuity rollover rules before making this decision.
In short, there are two ways to roll over your retirement account into an annuity — directly through a transfer, or indirectly through taking a qualifying withdrawal.

Rolling over some of your retirement savings into an annuity which will eventually provide guaranteed, secure lifetime income can be the answer to a lot of questions and concerns you have about supporting yourself after you’ve retired.

With the demise of pensions for most workers, many have found themselves on their own to chart out their retirement finances. The big question they face is: How do they do it?

Imagine you’ve built up a sizable retirement savings in your employer-sponsored retirement plan or your own IRA account, and you’re getting ready to retire. But without a pension, how do you make sure you have continuous income to fund your retirement years? Social Security won’t cut it. It’s too little, and who knows how long it will be there?

How do you use your savings to fund your retirement? How much can you withdraw at a time? How do you know how long you’ll need the money to last? What if you run out of money? What if you spend too little because you’re afraid of running out of money? In other words, how can you make the funds in your 401(k) or IRA more like a pension?

One popular option is to use a portion of the funds to purchase an annuity, which will provide you a stream of income like a pension.

The income can be structured to last the rest of your lifetime, or, if you are married, for two lifetimes. And if you don’t want lifetime income, you can create an income that lasts for a set period of time — 15 years, for example.

Your financial advisor can help you build a plan that is right for you.

A 401(k) is an employer-sponsored retirement savings plan that allows employees to save pre-tax money from their paychecks, often with a partial match from their employers. Money deposited into 401(k) accounts is not taxed until it is withdrawn. It gets its name from the section of the tax code that covers it.

By and large 401(k) plans, known as defined contribution plans, have taken the place of pensions, known as defined benefit plans. 401(k)s are the primary vehicle of employer-sponsored retirement savings.

An IRA is an individual retirement account in which the saver directly deposits pre-tax funds. Often, individuals who leave companies where they had 401(k) plans will roll the funds into IRAs.

Regardless of whether you own a 401k or an IRA, once a distribution is taken, it is taxable as ordinary income. Additionally, if you are withdrawing money prior to the age of 59 and a half, then the IRS levies an additional 10% penalty tax. The same rules of taxation apply when you roll a 401(k) plan or an IRA into an annuity.

Determining how much of your retirement savings should be in an annuity should start with an analysis of your routine expenses. Ideally, you should make sure you have a guaranteed income stream to fund at least 80% of your budget. This income stream can come from Social Security, a pension or annuities.

When you consider rolling your retirement savings into an annuity, you should be familiar with the types of annuities and the benefits and drawbacks of each. Some investment advisors say that variable annuities are not a good option because they can be expensive, complicated and unpredictable. Fixed annuities, however, are less costly to the purchaser and more reliable as far as an income stream.

You should consult a financial advisor to chart out your budget moving forward and determine how much of your retirement savings should be used to purchase an annuity. You should determine what type of annuity works best for you and whether you should purchase specific riders to modify the contract to meet your needs.

You could also use various strategies, such as annuity laddering, which takes advantage of different types of annuities to construct the income stream you need, or a split-funded annuity, which enables you to get the best of different types of annuities.

Another possible strategy is to delay receiving the annuity income stream as long as possible. That’s because your expected lifespan is part of the calculation an annuity provider uses to determine how big your payments will be. The shorter your life is projected to last, the higher the individual payments. Consequently, the older you are when you begin receiving payments, the higher the income payments will be.

Annuity rollover rules for retirement savings accounts can cause serious tax implications depending on the type of account.

The rules and implications can vary based on whether you’re rolling over money from a 401(k) plan, traditional IRA or Roth IRA. But for most retirement plans, the rules are straightforward.

Traditional IRAs and traditional 401(k) plans are deferred tax retirement accounts. That means you don’t pay income taxes on the money you contribute to the plans — but you pay taxes on the money you take out of them when you retire.

There typically are no tax implications for moving money from your traditional IRA or 401(k) plan into an annuity. The easiest way to do this is to make a direct rollover through the insurance company handling the annuity.

The money you roll over goes directly from your retirement plan into the annuity and you pay income taxes on the money you receive when you retire.

Roth IRAs and Roth 401(k) plans are after-tax retirement savings accounts. That means, you’ve already paid taxes on your contributions.

So, you don’t have to pay income taxes on the money you take out of a Roth IRA and roll over into an annuity. The same goes for a Roth 401(k).

Once you enter retirement, you can roll any Roth accounts into a Roth IRA annuity.

Annuity rollover rules are also affected based on whether you do a direct rollover or an indirect rollover.

Direct rollovers occur when you transfer your retirement account funds — within annuity rollover rules — directly into an annuity. Under these circumstances, direct transfers are tax free. Direct transfers are commonly done by mailing or wiring funds directly to the new plan provider, but on some occasions, the old plan provider may mail the check directly to you, payable to the new plan provider. This still counts as a tax-free direct transfer.

Indirect rollovers, however, are more complicated and have significant tax consequences if not executed correctly. Indirect rollovers involve withdrawing your funds from a retirement account — typically when you change jobs or other reason allowed under the tax laws prior to retirement. To remain tax-free, the funds must be rolled over within 60 days of distribution. Otherwise, the distribution is income taxable and may also be subject to the penalty for withdrawing funds prior to age 59 and a half.

Indirect rollovers have other consequences as well. Distributions made from qualified retirement plans, such as 403(b) annuities and 457 plans, are subject to automatic withholding tax in the amount of 20%. Internal Revenue Code considers the withholding of a distribution unless it is added to the 80% received and reallocated during the 60-day limit.

The advice here is simple: whenever possible use direct transfers.

There are two main situations in which it makes the most sense to consider rolling over your 401(k) or IRA into an annuity:

Most people who consider a retirement account rollover into an annuity are nearing retirement age and may be considering one or both options.

People near retirement may have saved up a sizable nest egg in a 401(k) or IRA. That gives you some options.

You may want to diversify your retirement funds by rolling over some of the money you’ve saved into an annuity — giving you both savings and a steady stream of income.

If you are worried about outliving your savings, rolling savings into a guaranteed lifetime income makes a rollover an option worth considering.

Can you roll your annuity over into your 401(k)? It depends.

First, your annuity would need to already be an IRA annuity. Second, your 401(k) plan would have to allow you to roll money from other tax-deferred retirement plans into it.

You can run into tax implications when rolling an annuity into a traditional 401(k). That’s because traditional 401(k) contributions are tax deductible but annuity contributions outside of a retirement account are not.

The IRS will not allow you to mix and match deductible and nondeductible contributions into the same account.

One solution may be to carry out a tax-free exchange of one annuity with another annuity. This is permitted under Section 1035 of the tax code.

The exchange will prevent you from having to pay income taxes or capital gains taxes on the exchange. But be aware of possible surrender charges that you may have to pay.

You should check with the person in charge of your employer’s plan. You should also check with your annuity provider and review the contract to make sure you’re able to take the funds from the annuity.