Annuity options in a retirement plan

Our expert tells a reader their options for shifting funds from an annuity.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: My wife and I are 55 years old and considering retiring in the next seven years. We have a retirement portfolio of more than $500,000 that includes $50,000 in annuities that we bought 20 years ago.

Would it be to our advantage to roll over these annuities into our IRA accounts? - J.C. Sauer, Marion, Iowa

Answer: First of all, the only money that you can rollover into an IRA account is money you have in an employer retirement plan such as a 401(k) that you want to move after you've switched jobs or retired, or funds that are already in another IRA account.

So unless you originally bought the annuities as an IRA investment (which is something I don't think people ought to be doing when they're still building their retirement nest egg) or the annuities were an investment option in an employer plan (which is unlikely unless you were in a 403(b) plan), you can forget about your idea of rolling over your annuity stash into your IRA.

I suspect, though, that the annuities you bought were not part of an IRA or employer plan. Most likely, they are what are known in the annuity biz as "nonqualified" annuities. Which is a fancy name for an annuity you buy from an insurance company (either through an insurance agent, financial planner or broker) with plain old after-tax dollars.

Unlike an IRA or 401(k), this type of annuity offers no immediate tax break. But your investment does rack up gains without the drag of taxes until you withdraw your money. At that point, all the gains are taxed at ordinary income tax rates (even if the underlying investments, as would likely be the case with a variable annuity, generated long-term capital gains).

You pay no tax on your original investment, which isn't surprising since you already paid tax on that money before investing it in the annuity. That said, however, the IRS generally considers all withdrawals taxable until the annuity's value drops to the value of your original investment. At that point, the withdrawals are considered a nontaxable return of your own money.

Okay, so with all that scintillating information out of the way, the question becomes just what can you do with the money in those annuities? Well, you have several options.

If you really need the money, you could just cash in your annuities altogether or begin pulling money from them a little at a time. Annuities generally have "surrender charges," or early withdrawal penalties, that typically run between 6 percent and 10 percent (although in some cases they can run as high as 20 percent). But those penalties typically disappear in 6 to 10 years, maybe 15 or 20 on the outside. You're probably beyond the surrender charge phase, so that's not an issue.

What is an issue, though, is your age. If you withdraw money from an annuity prior to age 59 1/2, you are hit with a 10 percent tax penalty on top of the regular income taxes that are due. Which means if you and your wife are in the 25 percent tax bracket, you would end up paying an effective tax rate of 35 percent on your annuity gains if you withdraw the money before you turn 59 1/2.

There is a way around the 10 percent tax penalty, though: annuitize, that is, convert the value of your annuity into regular payments based, say, on your life expectancy. (The 10 percent tax penalty is also waived on payments you take because you've become totally and permanently disabled and on payments made after the death of the annuity owner.)

You'll still owe income tax on the payments, but annuitizing gives you a little tax break there as well in the form of what's known as the "exclusion ratio." Essentially, the IRS considers a part of each annuity payment a return of your original investment, in effect, postponing the tax on your gains.

All in all, I'd say that at this point it probably makes sense to wait until you and your wife reach age 59 1/2 before dipping into your annuities. At that point, you won't have the 10 percent tax penalty to worry about, and you can decide whether you want to annuitize for guaranteed lifetime income (or, for that matter, income over a specified number of years), pull money out a bit at a time or just cash in the whole shebang.

That doesn't mean, though, that you should necessarily hold onto the annuities you now own. Many annuities charge total annual fees that can range upwards of 2 percent or more. Since you no longer have a surrender charge locking you in, you may want to consider switching into an annuity with much lower annual expenses, such as those offered by Vanguard, Fidelity, Schwab and T. Rowe Price to name a few companies. You do not want to cash out your existing annuity and then reinvest in a new one. That would trigger tax payments and a 10 percent tax penalty if you do so before age 59 1/2. Instead, you want to do a "1035 tax-free exchange," which is the way to move your money directly from one annuity to another without creating a tax bill. The company you're getting your new annuity from can fill you in on how to do this maneuver.

One caveat, though: before you do a 1035 exchange, make sure the annuity you're going into doesn't have surrender charges that will make an early exit costly. The companies I mentioned above sell annuities that do not carry surrender charges.

A couple of final thoughts. First, annuity taxation is replete with little pitfalls and dark corners that can trip you up, and possibly cost you money. I've given you the broad brush strokes here.

Before you make any moves, you may want to first take a gander at IRS Publication 575: Pension and Annuity Income or, better yet since Publication 575's dense prose makes Joyce's Finnegan's Wake seem like a Good Night Moon by comparison, consult a tax adviser who really knows his or her way around annuities.

Second, maybe this annuity investment worked out for you (hard to say since I don't know how much you originally invested.) But I find that annuities are the ultimate "sold, not bought" investments. It's rare I find annuity owners who really understand what they own.

So before anyone reading this column decides to buy an annuity, I'd recommend first reading my Annuity's Buyer's Guide. The story ran several years ago, but it's still relevant today for anyone who wants to understand the pros and cons of the various types of annuities out there, as well as what role, if any, annuities should play in your retirement planning.

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The fast track to kicking back

ETFs for the long run

Pensions: Annuity or lump sum?

Moving taxed funds from an IRA to a Roth IRA

Ask Walter a question: Click here or e-mail us at asktheexpert@turner.com.  Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.