(MarketWatch) Q: I read your article about annuities being a “tax time bomb”. None of that would apply when the annuity is in a Roth IRA because Roths are all tax free. Right?
— Cal
A.: Cal, I am generally not a fan of annuities in Roth IRAs or traditional IRAs.
The piece you read discussed annuity taxation for non-retirement accounts, also referred to as taxable or non-qualified accounts. The type of account dictates the tax consequences.
It is true that when using an annuity in a Roth IRA, the Roth IRA rules, rule. Taxes are based on what is distributed from the Roth IRA and when. If all the requirements are met, all the distributions are tax-free.
From this point, anytime I write Roth IRA, the same statements also apply to traditional IRAs.
The investments within a Roth IRA and the activity within a Roth IRA has no bearing on your tax bill as long as the types of investments in there are permitted. An annuity contract is a legal option for the type of investment you can put in a Roth IRA. However, most annuities are bad choices.
In the right situation, the type of annuity I most often find worth considering is a single premium immediate annuity (SPIA). Here you trade a one-time payment to the insurance company for a series of payments guaranteed payable for as long as you live. These can pay off nicely if you live past your life expectancy. The longer you live, the better. Knowing you can’t outlive the payment stream has an intangible value as well.
Most annuities sold to consumers are not SPIAs. They are deferred annuities bought to accumulate funds and will tout various guarantees. None of those guarantees are free and many of them are overpriced, some grotesquely so. The versions sold by agents, brokers, or “advisers” who are actually regulated as agents or brokers, typically possess cost structures that include high annual fees, surrender fees, market value adjustments, other restrictions when funds are removed from the annuity, or restrictions about what you can do with funds that remain in the contract.
I don’t believe it to be in a client’s best interest to add complicating factors and higher costs unless there is a clear and valuable payoff for accepting such terms. You have a vast world of investment choices available to you when you open a Roth IRA. Once you put money in an annuity contract, you shrink the number of possibilities to a relatively tiny set of choices given to you by the insurance company.
I have yet to see an annuity that would provide a return at a comparable risk level that you couldn’t easily replicate without the restrictive terms and additional costs of the annuity contract. You are likely much better off filling your Roth IRA or traditional IRA with plain vanilla investments in an array that fits your needs and your risk profile.
