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Do Annuities Belong in IRAs?

Posted by Keith on April 2, 2007 at 1:36 pm  

Do Annuities Belong In IRAs?

My advisor is recommending that I “lock in some profits” within my IRA by putting my gains inside a fixed-rate annuity paying six percent. The annuity would stay inside the IRA. Is this a good idea? He also said I could get out of the annuity at any time without penalty.

– Ethel, Dover Maine

Keith’s response

First, the general rule is that you should not place annuities inside an IRA. Why pay to protect the money from taxes twice?

However, unlike some advisors, I do not have a viscerally negative response to the idea of placing an annuity within an IRA under certain circumstances.

There are really two non-tax reasons why you would consider such a thing:

-To lock in gains during your lifetime: Here the vehicle of choice would be a low-or-no surrender charge fixed-rate annuity. This can be particularly attractive for older investors who have reached a point where they are far more interested in the return of their principal, than in the return on their principal. Those same investors might also elect to convert the annuity to a stream of payments to cover their mandatory IRA distributions, for example; and

-To protect your spouse in the event you have the poor timing to die during a down market: For example, at DeGreen Wealth Management, many of our affluent clients loved the idea of making their higher-risk investments (say, in the tech sector) through variable annuity sub accounts within their IRA. They knew that even if their investments went to hell in a hand basket, their surviving spouse would be guaranteed to receive, upon the other spouse’s death, at least what they had invested, plus usually up to five percent compounded – again, regardless of the market performance of the sub-accounts within the annuity.

I will never forget how this approach helped a client of ours — the wife of a famous sports figure. It was early 1999. The tech bubble had not burst yet, and like most folks back then, they were both eager to invest in tech stocks despite our cautionary warnings.

Although we placed the vast majority of their investments in fee-based accounts that we managed, we also knew that the husband had health issues. We therefore recommended that part of their assets be placed in a variable annuity and that they do their higher-risk (translation: technology) investing within that annuity’s sub accounts. This way, we explained, the wife would be protected in the event of a market downturn, if the husband passed away.

Sure enough, two years later he died. On the day he died, their tech investments within the annuity were down 60%, as were everyone else’s. When she came to our office after the funeral, she was distraught. She had not only lost her husband, but, she thought, much of their net worth.

But – and this was a wonderful feeling – we told her to forget what the statements said. Instead, she would receive a check for the full amount they had invested in the annuity, plus five percent compounded since the day they purchased it. And she did!

Meanwhile

Some media financial advisors – Jane Bryant Quinn comes to mind – just hate annuities. They claim the fees are too high and that by using an annuity you convert less-taxed capital gains into ordinary income.

But Ms. Quinn has apparently never sat across a table from a widow holding back tears, first of fear, and then of relief, as she learned the money she thought was lost, was still there for her.

And besides, all your withdrawals from an IRA are going to be taxed as ordinary income anyway. Adding an annuity to the IRA mix has zero impact on the taxation of withdrawals.

However,

I must say I am suspect of the claim by your advisor that you can get into and out of a six-percent fixed-rate annuity at will, without a surrender charge. However, there are some very flexible shorter-term fixed rate annuities out there, so this is possible. Be certain your advisor lays all his cards on the table: What he is being paid to sell you the annuity, and how the annuity works. Also, be certain to read the prospectus for hidden charges. Finally, don’t do it unless you have clear need as described above.

–Keith


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