In the good ol’ days, Americans relied on pensions to give them an income during retirement. They didn’t have to worry about 401(k)s or IRAs and tax rules because they had defined-benefit pension plans that took care of the income for them.
Today, most Boomers can not only expect to live longer than their grandparents did, but they’re also on their own when it comes to funding retirement. The good news is that it’s not that hard to get yourself the same kind of pension checks that your grandparents had; you can roll your money over into an annuity. Here is what you need to know about the tax rules because when it comes to this pot of money, Uncle Sam is watching you.
The Difference between Qualified and Unqualified
Being told that you qualify for something is usually good news, except in the case of taxes. Advisors use the term “qualified money” when talking about the funds inside of a 401(k0, IRA, or other tax-deferred retirement plans. These savings accounts were created as a replacement to the traditional defined-benefit plans to help you save for retirement.
The deal is a good one: you get to put money into an account before paying income taxes on it. This allows the money to benefit from triple compounding. It grows more robustly because 1) you don’t have to pay income taxes on the portion of your paycheck that you save, 2) you don’t have to pay taxes on the returns that this money earns, and 3) the money you would have paid in taxes instead stays in the pot to grow and earn additional returns.
Because of this terrific deal, Uncle Sam has a few rules about these accounts.
- There are limits on how much you can contribute. In 2018, the limit for a traditional IRA is $5,500, or $6,500 if you’re age 50 or older. For 401(k), 403(b), and most 457 plans, the limit is $18,500.
- You cannot withdraw this money before the age of 59 ½ without having to pay a 10 percent penalty.
- Once you do decide to spend this money, congratulations, it qualifies—for taxes! You’ll be required to pay income taxes on the withdrawals.
- You are also required to withdraw a minimum amount—known as your Required Minimum Distribution or RMD—once you reach the age of 70 ½.
The Difference that an Annuity Makes
An annuity is a contract between you and an insurance company where, in exchange for a sum of money, the insurance company agrees to pay you a regular income. The amount of income you’ll get for your money depends on your age, life expectancy, the type of annuity you buy, and the amount of your deposit.
You can choose to buy an annuity that will start paying you income right away, or you can buy an annuity that grows your money for a period of time in a more secure vehicle before you start the income payments. Income payments can also give income to your spouse or your beneficiaries, depending on which type of annuity you choose.
Why an Annuity Purchase Can Be Tax-Free
Because so many people are retiring without a pension these days, annuity sales are booming. Consumers have a lot of choices to make concerning what kind of annuity to get; one thing you don’t have a choice about, however, is paying the taxes. Here is what you need to know:
If you choose to cash out the money in your 401(k) or IRA, you may trigger a taxable event and you could be hit with a distribution tax. If Uncle Sam thinks you’re spending all of your savings, he’s going to be standing there with his hand out, asking for that income tax you’re qualified to pay.
You can get around this by rolling over your IRA or 401(k) into an annuity. Annuities that are funded with an IRA or 401(k)-type retirement plan are qualified plans, and as such, the insurance company will create what is sometimes called an IRA annuity into which you can deposit your retirement savings.
While this type of transaction can be done without triggering a taxable event, the IRA annuity, like a 401(k) or traditional IRA, is not a tax-free product. You’ll still have to pay taxes on the money when you take it out as income, but you’ll only owe taxes on the amount you spend rather than on the entire lump sum. Ask yourself, which would you rather pay: a 25 percent tax on $500,000 or a 25 percent tax on $50,000?
How to Do the Roll Over Without Complications
There are two ways to accomplish the purchase of an annuity using the money in your 401(k) or IRA: the easy way, and the complicated way. Both ways may result in a tax-free transaction.
The complicated way is to receive the money directly from your employer. If they write you a big fat check for the full amount in your savings account, they will be required to withhold a percentage for taxes (a percentage which will include a 10 percent penalty if you are younger than 59 ½). When using that check to purchase your annuity, you would then have to make up the difference caused by the missing money withheld for taxes before being reimbursed. The IRS will credit that money back to you when you file that year for your income taxes, provided you can prove that the rollover was made within 60 days of receiving the big fat check.
The easy way to avoid this complication is to do a direct rollover. Your employer or the company that is transferring the money can either do a direct wire transfer or they can write that big fat check out to the insurance company instead of payable to you. To find out your employer’s procedures for issuing such checks, be sure to contact your Human Resources department.
In some cases, an annuity salesperson might obtain a “rate hold” from an insurance company that promises you certain terms, in which case you might feel under pressure to make the transfer as soon as possible. In other cases, investors who buy an annuity are paying extra for a tax-deferred benefit that they already have. Be sure you understand all the terms and conditions that apply before you get into an annuity. If you have any questions about the process or how your retirement money may be taxed when you buy an annuity, give one of our advisors a call at (888) 440-2468. We’ll be happy to review your situation at no cost or obligation to you.