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IRA Annuities: Beware of Death Benefit Taxation

When an immediate annuity is purchased inside an IRA, the IRA becomes subject to an entirely different set of RMD rules.

Natalie Choate, 02/10/2017

Question: The following question has come up with a client. The original IRA owner, "Bill," purchased from an insurance company, inside his IRA, an immediate annuity that would pay him $500 per month for life. The single premium was $100,000, and the contract had a premium refund feature, so that on Bill's death the insurance company would pay to his daughter and beneficiary, Jill, the amount of the original IRA premium minus whatever had been paid out to Bill during his life. Since Bill had received $80,000 prior to his death in monthly annuity payments, Jill is to receive $20,000. However, the insurance company is saying that the $20,000 cash refund cannot be transferred directly into an inherited IRA for Jill--it must be paid to her personally. And of course if she receives the money she cannot perform a 60-day rollover as that isn’t allowed for nonspousal beneficiaries.

Is the insurance company right about this? Is there no way to avoid immediate taxability of the $20,000 cash refund?

 Answer: I think the insurance company is right on this, though I'm not 100% sure.

When an immediate annuity is purchased inside an IRA, the contract and the account step out of the regular minimum distribution rules that we know so well. Instead, the IRA becomes subject to the special separate RMD regime that applies to defined benefit pension plans and "annuitized" defined contribution plans.

This special regulation dispenses with account balances, applicable divisors, and other concepts that are the basis of the RMD rules for defined contribution plans. Instead, the regulation dictates what type of annuity contract can be purchased. There is a broad menu of standard forms of fixed-term and life annuities with or without minimum guaranteed terms, and with or without a survivor benefit (lump sum or annuity). The regulation liberally permits just about any type of annuity people would normally purchase for retirement income, but prohibits annuities that would shift too much value to the death beneficiary. For example, an IRA can purchase an immediate annuity providing level monthly payments to the IRA owner for his lifetime but cannot purchase a 200-year fixed-term annuity.

The regulation seems to say (though it could be clearer) that once the participant’s account has purchased one of these permitted annuity contracts, all payments made under the annuity contract are required minimum distributions. As RMDs, the annuity payments (either to the participant or the beneficiary) are not eligible for rollover.

From one perspective, that rule would seem to appropriately apply only to annuity payments, not lump sums. So it might seem that if the death benefit/premium refund feature of Bill’s contract could have (under the IRS's annuity regulation) been paid to Jill in the form of an survivor annuity, it would appear that there should not be a problem transferring it into an inherited IRA, which would of course have to be paid out over Jill's life expectancy. However, one of the irrational (if it's really true, which it is to the best of my ability to figure it out) things about the annuity rules is that all distributions under the annuity contract apparently are nonrollable RMDs—even if the participant could have legally purchased an annuity that provided a much slower/smaller/longer payout!

For example, if you buy a 10-year immediate annuity, all the payments you receive are (apparently) nonrollable RMDs, even if (based on your age and life expectancy) the IRS’s RMD rules would have permitted you to buy a 20-year annuity which would have provided much smaller payments.

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is a leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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