Question: My mother, 73 years old, has an annuity with an option to convert to a lifetime income. If she continues taking the Required Minimum Distributions (RMDs), eventually all of the principal will be consumed. When is the best point to exercise the option to convert to guaranteed fixed income for life?
Answer: First, let’s start with the basics. An annuity is a product sold by insurance companies. In the accumulation phase you give your money to the insurance company to invest and any earnings or gains grow tax deferred until those funds are distributed to you or your beneficiaries. The product can be sub-divided into either a fixed annuity where the insurance company pays a fixed interest rate, or a variable annuity where you get to choose among a number of mutual funds that invest in stocks, bonds or other fixed income instruments. With annuities, you can set up your account as a personal account or as a retirement account. The typical retirement account uses funds from a rollover IRA. Annuity products have numerous ‘options’ and can be very complex so you’ll want to consult with a financial expert before making any big decisions.
In the distribution phase, you tell the insurance company that you now want to convert your policy to a lifetime monthly income. Again there are numerous options including a lifetime income that ends when you die or you can choose a lifetime income with payments guaranteed for a minimum number of years, called a ‘period certain’. Choosing a ‘period certain’ reduces your monthly payments.
The main criticisms of annuities include:
· High costs. This includes relatively high commissions paid to the salesperson and high annual costs associated with maintaining the product. These costs can easily exceed 2% per year. You’ll want to ask your agent what the total annual fees and costs are for your policy as well as what commissions will be paid.
· Reduction of benefits for heirs. Beyond any guaranteed payments, at death, the contract ends and there is nothing left for heirs.
Under most circumstances, I do not recommend buying an annuity with your IRA or other retirement account money since it’s like placing a tax-deferred plan inside another tax-deferred plan and the redundancy usually ends up with you paying unnecessary fees.
In your case, you have a number of options:
1. Continue your current strategy of taking required minimum distributions and place any unused money in a personal investment account for your mother.
2. Roll over the annuity into a regular IRA account. Be sure to check and make certain there are no penalties or surrender charges for doing this. This would likely result in a significant reduction of annual fees. Under this option, required minimum distributions will continue.
3. Convert her annuity to lifetime payments. If you choose this option, as with all distributions from a retirement account, the monthly payments will be treated as ordinary income for income tax purposes.
The best choice for your mother will center on how important it is that she have a guaranteed monthly income for life versus having the opportunity to leave more money to heirs. If her health is fair to poor, you’d be more likely to avoid annuitizing. If her health is excellent, this favors annuitizing her money. At age 73, her required minimum distribution is only about 4% so her money should last quite a while!