required minimum distribution annuity

The first thing we need to do, when dis­cussing required min­i­mum dis­tri­b­u­tion annu­ity rules, is to clas­si­fy annu­ities into two categories:

  • qual­i­fied annuities
  • non­qual­i­fied annuities

Required Minimum Distribution — qualified annuities

A qual­i­fied annu­ity is an annu­ity held in a tax-shel­tered retire­ment plan such as an IRA, a 401(k), a prof­it-shar­ing plan, etc. When you have an annu­ity in such a plan, the required min­i­mum dis­tri­b­u­tion of the annu­ity is dic­tat­ed by tax rules regard­ing the plan in which the annu­ity is held.  For exam­ple, if the annu­ity is held in an IRA, then you must start tak­ing dis­tri­b­u­tions from the IRA at age 70 ½.  That is the rule that applies to the pan in which the annu­ity is held. The IRS doesn’t real­ly care what you hold in the IRA, whether it is annu­ities, stocks, bonds, or mutu­al funds.  To restate, there is no required min­i­mum dis­tri­b­u­tion for an annu­ity which is a qual­i­fied annu­ity because the dis­tri­b­u­tion require­ments are for the plan (IRA, 401k, etc.) not the invest­ments in the plan.

Required min­i­mum dis­tri­b­u­tions are based on the fair mar­ket val­ue of invest­ments in your plan.  With stocks, bonds and mutu­al funds, the fair mar­ket val­ue is sim­ply the num­ber print­ed in the news­pa­per on the pri­or Decem­ber 31.  But the fair mar­ket val­ue of an annu­ity is not sim­ply the val­ue shown on your statement.

Your annu­ity may have spe­cial fea­tures such as a guar­an­teed income rid­er.  That rid­er has a fair mar­ket val­ue and is part of your bal­ance on which to cal­cu­late your RMD.  Good news:  you don’t need to take a cal­cu­lus class.  The annu­ity issuer will send you form 5498 each year which reports the annu­ity fair mar­ket val­ue which you use to cal­cu­late the RMD on your IRA or oth­er retire­ment accounts.

Exception to Required Minimum Distribution — qualified annuities

There is one recent excep­tion to this treat­ment of required min­i­mum dis­tri­b­u­tions on annu­ities (enact­ed by Con­gress in 2014).  There is a spe­cial type of annu­ity called a qual­i­fied longevi­ty annu­ity con­tract (QLAC).  If you hold such an annu­ity in an IRA or qual­i­fied retire­ment plan (401k, 403b, etc.), you do not need to start dis­tri­b­u­tions until age 85.

This par­tic­u­lar type of annu­ity is designed to pro­tect peo­ple against liv­ing too long.  The prob­lem with liv­ing too long is that you can run out of mon­ey.  A typ­i­cal use of this type of annu­ity is to pur­chase at age 65 have the bal­ance grow for 20 years and then start life­time month­ly pay­ments at age 85.  If you die before reach­ing age 85, your ben­e­fi­cia­ries don’t receive any­thing (unless you have opt­ed for low­er life­time pay­ments and a return of pre­mi­um rid­er).  While that may seem like a “bad deal,” you will like­ly not find any oth­er guar­an­teed source of life­time income that pays as much.

You can think of such an annu­ity like a 2nd Social Secu­ri­ty check in that the pay­ments are for life and ben­e­fi­cia­ries get noth­ing when you pass.

As to the required min­i­mum dis­tri­b­u­tion annu­ity rules for QLACs, when held in an IRA or qual­i­fied plan, you do not include it in your account bal­ance to com­pute your required min­i­mum dis­tri­b­u­tion.  Mon­ey placed in a QLAC is exempt from required min­i­mum distributions.

IRS does not per­mit you to place all of your IRA or 401(k) account into a QLAC. A par­tic­i­pant in a 401(k) or qual­i­fied plan or IRA may use the small­er of 25 per­cent of his account bal­ance or $125,000 to pur­chase a qual­i­fy­ing longevi­ty annu­ity. More QLAC details here.

Required Minimum Distribution — nonqualified annuities

Now let’s turn our atten­tion to non­qual­i­fied annu­ities.  These are annu­ities you pur­chase with reg­u­lar mon­ey such as mon­ey you have in a sav­ings account or CD or oth­er after-tax account.  Most peo­ple use reg­u­lar funds to buy an annu­ity because inside the annu­ity, the funds will earn inter­est on a tax-deferred basis.  There is no IRS required min­i­mum dis­tri­b­u­tion annu­ity rules for non-qual­i­fied annu­ities.  How­ev­er, the insur­ance com­pa­ny that issued the annu­ity almost always requires you to begin tak­ing dis­tri­b­u­tions by age 85.  Note that this is not an IRS require­ment but the issu­ing insur­ance com­pa­ny will sim­ply start send­ing you pay­ments from your annu­ity at a spec­i­fied date, in most cas­es age 85.

Required minimum distribution annuity rules when the owner or annuitant dies.

Let’s first clar­i­fy some terms.  The own­er of the annu­ity is the per­son whose mon­ey has pur­chased the annu­ity and who con­tin­ues to own the annu­ity as their asset in their name.  The annu­i­tant is the per­son on whose life the annu­ity is based.  Even though there is no life insur­ance ben­e­fit includ­ed with­in the annu­ity, remem­ber that annu­ities are issued by life insur­ance com­pa­nies.  There­fore, they were struc­tured long ago with one par­ty being an annu­i­tant on whose life the annu­ity is based.  In most cas­es, the own­er and the annu­i­tant are the same per­son but not always.

Let’s take an exam­ple.  John, age 60, pur­chas­es a non­qual­i­fied annu­ity.  He is the own­er.  He names his son Stu­art as the annu­i­tant.  Both John the own­er and Stu­art the annu­i­tant name ben­e­fi­cia­ries in the case of their death.  John names his son Stu­art is ben­e­fi­cia­ry.  So when John dies, Stu­art will have all the rights and choic­es of a ben­e­fi­cia­ry.  We will dis­cuss these choic­es and rights in just a moment.

Stu­art names his two sons as ben­e­fi­cia­ries.  So if Stu­art dies.  Then his sons will inher­it the annu­ity bal­ance and have the required min­i­mum dis­tri­b­u­tion annu­ity options list­ed below.  There can be some com­pli­ca­tions (e.g. estate and gift­ing issues) when the own­er and the annu­i­tant are not the same per­son but this sim­ple exam­ple is an illus­tra­tion of such a case.

When either the own­er or the annu­i­tant dies, their ben­e­fi­cia­ries have required annu­ity min­i­mum dis­tri­b­u­tions.  They can­not choose to have the mon­ey con­tin­ue accu­mu­late on a tax-deferred basis.

If own­er dies pri­or to annu­iti­za­tion (annu­iti­za­tion is the process of tak­ing life­time income payments)

The ben­e­fi­cia­ry has the required min­i­mum dis­tri­b­u­tion annu­ity options:

  • imme­di­ate lump sum
  • com­plete with­draw­al with­in 5 years of death
  • annu­iti­za­tion (over the life of the ben­e­fi­cia­ry) to start with­in one year of death. If spouse is sole sur­viv­ing ben­e­fi­cia­ry, the spouse can elect to become the new own­er and con­tin­ue the con­tract and income tax defer­ral. If the ben­e­fi­cia­ry is a grantor trust, death of grantor (the annu­ity own­er) trig­gers manda­to­ry distribution.

These required min­i­mum dis­tri­b­u­tion annu­ity rules apply to all con­tracts issued after 1/18/85.

If own­er dies After annuitization:

Pay­ments con­tin­ue to owner’s ben­e­fi­cia­ry, based on annuitant’s life and type of pay­ment plan chosen.

The same rules above apply to the death of the annu­i­tant and the dis­tri­b­u­tion require­ments forced on the annuitant’s beneficiaries.