Tax Implications of an Immediate Annuity Bought With Roth Funds

by Ciaran John

You can turn your retirement savings into an income stream by purchasing an immediate annuity with your Roth individual retirement arrangement (IRA) account proceeds. Many people invest Roth funds in these products so as to create tax-free income streams. However, Roth immediate annuity distributions are not always tax free and in some cases you incur tax penalties for making withdrawals.

Immediate Annuities

You purchase an immediate annuity contract with a single premium. The annuity company applies interest to your premium and then converts the principal and interest into an income stream. You can buy immediate annuities with terms as short as five years although in many cases the income stream lasts for the duration of your life. You normally start to receive monthly income payments within a month of buying the contract and you cannot convert your annuity back to a lump sum after the payments commence.

Roth IRAs

You make contributions to a Roth IRA on an after-tax basis, so you can withdrawal your principal at any time without incurring a penalty. You can make withdrawals from a Roth IRA annuity without having to pay income tax, but only if you meet seasoning and age requirements. You must keep funds inside a Roth for at least five years and you cannot make withdrawals until you reach the age of 59 1/2. Therefore, if you meet these two conditions, you can roll funds from an existing IRA into an annuity and immediately begin to receive tax free income payments.

Premature Withdrawals

If your immediate annuity contains both taxable and non-taxable funds, then your monthly income payments are structured to consist of both a return of principal and some taxable earnings. If you buy an immediate annuity and you do not meet the Roth withdrawal age or seasoning requirements, you have to pay federal and possibly state income tax on the portion of the withdrawal that consists of your earnings. You also pay a 10 percent premature withdrawal tax penalty on the taxable portion of your monthly income payments.

Considerations

If you die, your Roth IRA beneficiaries do not have to pay income tax on distributions from your Roth account. When you buy an immediate annuity, the income payments usually end when you die. If funds remain in the account at that time, the annuity provider rather than your beneficiaries gets to keep the proceeds. However, some insurers include optional riders on annuity contracts that obligate the annuity company to make monthly payments for the greater of a set number of years or your life expectancy. If you die, the payments go to your designated beneficiaries. As you might expect, you pay a price for these riders, as insurers reduce your monthly benefits if you buy a contract that could extend beyond the duration of your life.

Photo Credits

  • Digital Vision./Photodisc/Getty Images