Rolling Your IRA or 401(k) into an Annuity

Rolling over some of your retirement savings into an annuity with 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 nest egg in a 401(k) or 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 that 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?

The main way to do that would be to use a portion of the funds to purchase an annuity, which will provide you a stream of income like a pension. The income could be monthly, quarterly or once a year. It could be for a set number of years or the rest of your life, depending on the terms of the annuity.

So 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?

Well, the Internal Revenue Service allows direct rollovers because it considers them permissible transfers from one qualified retirement account to another qualified retirement plan. You won’t have to pay taxes on the rollover transaction, unless the rollover is to a Roth IRA, so long as you complete it within 60 days of the withdrawal. But you do have to report it to the IRS.

A rollover can be done one of two ways: you can transfer funds directly from your retirement account to an annuity or if you have found a new job or retired and no longer participate in the 401(k), you can take a qualifying withdrawal and purchase an annuity within 60 days. If you move the money more than 60 days from withdrawing it, it will be subject to a 20 percent withholding charge.

Some retirement plans offer the option of purchasing a deferred annuity as part of the account. This is known as a Qualified Longevity Annuity Contract and is a relatively new creation of the U.S. Treasury Department.

The investment tool turns funds in an IRA, 401(k) or other qualified retirement plan into lifetime income without violating required minimum distribution rules for people turning 70 ½. It gives retirees financial security and comfort knowing that they won’t outlive their money as they grow older.

The government limits how much of your account can be used to purchase one of these QLACs. You can use either 25 percent of the account total or $125,000, whichever is the lesser amount.

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 from them into IRAs.

Another form of IRA, known as a Roth IRA, involves the deposit of money that has been taxed. When money is withdrawn from a Roth IRA, it is not taxed.

When pre-tax money is used to purchase an annuity, then the stream of payments is taxable in total as income. When annuities are purchased with money that has previously been taxed, only the earnings are taxed when the annuity holder receives payments.

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 percent 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.

In addition to fees charged for annuities, you risk losing part of your investment when you die, meaning you may not be able to leave your money to your loved ones. Although there are tax benefits to owning an annuity, they may not add to the tax protections already provided by 401(k) and IRA accounts.

You should consult a financial planner 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.

Can you roll your annuity over into your 401(k)? It depends. If your 401(k) plan allows you to roll money from other tax deferred retirement plans into it, you may be able to do that with an annuity. This should be the case only if your annuity is already in another qualified retirement account, such as an IRA or another 401(k) account. That’s because the tax status of the funds would remain the same.

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.