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Annuitizing an IRA

Which set of distribution rules should you use?

Natalie Choate, 02/11/2011

Do you have your own solutions/suggestions? Leave a comment at the end of the article!

Natalie Choate will be speaking at a location near you if you live in Kansas City, Mo. (Feb. 23); Boston suburbs (March 4 and June 3); Houston (March 22); San Francisco  (April 27); Chicago (May 3); Jacksonville, Fla. (May 10); Charlotte, N.C. (May 11); Wilmington, Del. (May 26); Indianapolis (June 10); South Bend, Ind. (Sept. 15); or Memphis (Dec. 1). See all of Natalie's upcoming speaking events at www.ataxplan.com.

The IRS has one set of minimum distribution rules for "defined contribution plans" and another set for "annuitized plans." It's not always clear which rules apply.

Question: A 70-year old client owns a variable annuity contract inside his IRA. The contract provides a guaranteed life income feature that begins whenever the client triggers it, and overrides the value of the underlying investments. To provide retirement income for himself, the client triggered the provision upon reaching age 70, at a time when the contract's cash value base was $1,000,000, so now he is guaranteed to receive six percent of that cash value ($60,000 per year) for the rest of his life. The cash value of the contract will continue to be adjusted upward and downward for changes in the value of the underlying investments and to reflect distributions, but as long as he does not make any withdrawals in excess of the $60,000 per year the payments to him will continue for life even if the cash value of the contract goes below zero. Furthermore, if there is still a cash value at his death, it will pass to his beneficiary. How is this contract treated for minimum distribution purposes?

Natalie: The IRS has one set of minimum distribution regulations for "defined contribution plans" (also called "individual account plans") and another set for "defined benefit plans" (including defined contribution plans that have been "annuitized"). The two sets have completely different rules and are based on completely different concepts. In fact, if an IRA has been partly "annuitized," the IRA is treated as two separate plans for minimum distribution purposes-one set of rules applies to the annuitized portion, and the other set of rules applies to the rest of the account.

The defined contribution rules are the most familiar: The annual minimum required distribution is computed by dividing the prior year-end account balance by a life expectancy factor obtained from an IRS table.

The defined benefit/annuity minimum distribution rules take a different approach. There is no concept of computing an annual distribution, and no need to look at a prior year end account balance. Instead, these rules dictate what type of annuity can be purchased by an IRA or other retirement plan. Basically, only life annuities, or joint life annuities with the designated beneficiary, are allowed, but there can be annuities for fixed terms (or with minimum guaranteed terms) that do not exceed the applicable life expectancy. Payments under the annuity must be level, or increase by no more than a cost of living adjustment or specified fixed annual percentage. Once the annuity is in place, all distributions under the contract are considered "minimum required distributions."

And the IRS rules specify that a variable annuity contract, until it is actually "annuitized," is treated as just another asset held inside an individual account plan, with special valuation rules that apply.

The trouble with this neat little bifurcated universe is that the insurance companies keep coming up with new hybrid products. It's not always clear which set of rules applies to these products. Your client's guaranteed income variable annuity is a perfect example. It has a cash value (so to that extent it behaves like a defined contribution/individual account plan) but it also has a guaranteed life income feature (like a true annuity).

Recently, the IRS ruled that a similar sort of guaranteed withdrawal product had to be treated as an annuity contract for purposes of the spousal consent rules applicable to qualified retirement plans (spousal consent required in order for employee to take retirement distributions in any form other than a qualified joint and survivor annuity). But as yet there are no IRS pronouncements on how the minimum distribution rules apply to these hybrid contracts.

There are two minimum distribution concerns we would have about a product like this:

* First we want to be sure that the contract complies with the minimum distribution rules.

* Second we need to know the status of distributions the client receives; any distribution that is a minimum required distribution cannot be rolled over.

Until there is an IRS pronouncement, a client may be forced to be cautious and conservative regarding how the minimum distribution rules may apply.

One thing is clear: The life annuity itself does not violate the minimum distribution rules, because it lasts only for the client's own actual life. The defined benefit/annuity minimum distribution rules always permit an individual to buy a level payment single life annuity for his own life.

The potential compliance problem that arises would be if the cash value of the account increases beyond what is needed to support the $60,000 life annuity. The only way the client can be sure he is complying with the minimum distribution rules is to withdraw from the account, each year, the $60,000 minimum guaranteed payment, or (if greater) the minimum distribution computed based on his age and the prior year-end cash value. Such extra withdrawals might impair his guaranteed income stream, unless the contract has an exception permitting minimum required distributions to be made without prejudice.

The next problem is whether each $60,000 annual distribution is considered a minimum required distribution, which would be the case if this is treated as an "annuitized" IRA. If the guaranteed payments are considered minimum required distributions, they cannot be rolled over to another IRA.

For many clients, these questions will not be of significant concern because (1) in many cases there is almost no chance the cash value will increase after the guaranteed payout begins and (2) in most cases the guaranteed income payments are for spending, with no desire to "roll them over" into another IRA. However, for clients who may wish to roll over some of their guaranteed payments, and/or where cash value may grow significantly, the insurance companies issuing these products may wish to obtain an IRS ruling regarding their minimum distribution treatment.

Resources: The minimum distribution rules are contained in Internal Revenue Code § 401(a)(9) and Treasury Regulations § 1.401(a)(9)-0 through § 1.401(a)(9)-9; § 1.403(b)-6(e)(2); § 1.408-8; and § 54.4974-2. For explanation of the minimum distribution rules applicable to defined contribution and individual account plans, see Chapter 1 of the NEW edition of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed., 2011), which can be purchased through www.ataxplan.com, Amazon.com, or 800-247-6553.  For explanation of the minimum distribution rules applicable to defined benefits and annuitized plans, see Natalie Choate's Special Report: When Insurance Products Meet Retirement Plans, downloadable at www.ataxplan.com. For ruling discussing status of similar contract under the qualified joint and survivor annuity rules, see PLR 2010-48044 (12/3/10).

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Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the 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.

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