Are Variable Annuities Subject to Required Minimum Distributions?

Variable annuities are insurance contracts that provide tax-deferred growth of assets that can later generate a guaranteed income stream, thus making them popular vehicles for financing retirement. Like other investment products, variable annuities can be held as either qualified or non-qualified for tax purposes.

Qualified contracts—those held in IRAs or other tax-advantaged plans, like 401(k)s—are subject to the same required minimum distribution (RMD) rules as other investments in qualified retirement plans. Non-qualified contracts offer tax-deferred growth of after-tax funds and have no required withdrawals until annuitization, as defined by the annuity's contract.

Roth IRAs have no minimum distribution requirement until after the death of the account owner. A surviving spouse who inherits a Roth IRA is not subject to required minimum distributions. All other beneficiaries of inherited Roths are required to take distributions, either based on their own life expectancy or the five-year rule.

Effects of Required Distributions

The Internal Revenue Service (IRS) generally requires owners of IRAs and other qualified retirement accounts to begin taking withdrawals once they reach the age of 72 (or 73 starting in 2023). The amount of this RMD is determined by an age-based divisor and the balance in the account. A hefty penalty of 25% is imposed if the minimum is not withdrawn, but this penalty can be reduced to 10% if corrected promptly.

Under certain circumstances, the penalty may be waived if the account owner can show the IRS that not taking the payment was due to error and that they are doing what is necessary to remedy the error. The account owner must submit a letter of explanation along with IRS Form 5329.

Having to take withdrawals can create fear for retirees as life expectancies lengthen and the possibility of outliving retirement savings increases. The guaranteed lifetime income rider available for purchase on some variable annuity policies can help solve this problem.

RMD Effects on Benefits

Distributions can negatively impact investment performance and sometimes other benefits to the annuity contract, such as lifetime income riders and death benefits. When evaluating a variable annuity for qualified monies, it is very important to understand how RMDs are treated and the effect they have on the policy.

For example, when MetLife sold annuities, it offered the Guaranteed Minimum Income Benefit Plus rider on its qualified contracts. This benefit treats RMDs as a percentage withdrawal against the guaranteed income base and not the total account value. This helps to maintain the investment's ability to grow.

Required distributions should not stop investors from considering the valuable benefits offered by variable annuities. Investors and financial planners should work together to find a contract that works well with RMDs to maximize investment growth to last through retirement.