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.