Mixing Annuites and IRAs

According to the Investment Company Institute, 68% of households with IRAs have mutual funds in those accounts. That’s followed by individual stocks (41%), annuities (35%), and bank deposits (25%). Therefore, annuities are among the most common IRA holdings; they are also among the most controversial because many observers assert that annuities don’t belong in an IRA.

Defining the terms

To understand this seeming contradiction, you should know some terminology. Generally, the most heated debate does not involve immediate annuities, which also may be known as income or payout annuities. Here, you give a sum of money to an insurance company in return for a specified flow of cash over a specified time period, perhaps the rest of your life.

            Deferred annuities are a different story. With these investments, the money you contribute can grow inside the annuity contract. Different types of deferred annuities offer various ways that the amounts invested can grow over the years. Regardless of the method or the amount of accumulation, earnings inside the annuity aren’t taxed until money is withdrawn.

            Critics of holding deferred annuities inside an IRA say that they are redundant. Any investment inside an IRA is tax deferred or tax-free (with a Roth IRA), so you don’t get any tax benefit by investing IRA money in a deferred annuity. Why pay the costs that come with a deferred annuity when you get the same tax deferral with mutual funds or individual securities or bank accounts held inside your IRA?

            Because there might be advantages as well as drawbacks. Deferred annuities offer various guarantees, which might include certain death benefits and certain amounts of cash flow during the investor’s life, regardless of investment performance. These guarantees may be a valid reason to include a deferred annuity in an IRA, some annuity issuers and sellers contend.

            Among different deferred annuities, death benefits and so-called “living benefits” vary widely. Some can be extremely complicated. If you are interested in a deferred annuity, our office can explain the guarantees in the contract, so you can make an informed decision.

Verifying value

Another thing to consider when deciding whether to hold a deferred annuity in your IRA, is that these annuities must be valued for purposes such as Roth IRA conversions and required minimum distributions (RMDs). This also will arise if you already have such an annuity in your IRA. The reported value of the annuity contract may not be the appropriate number.

            Example: Sarah Thomson invests $50,000 of her IRA money in a deferred annuity that offers several investment options. After this outlay, Sarah’s investments decline, so her annuity account is now reported at $40,000. Sarah decides this reduced value would generate a lower tax cost on a conversion to a Roth IRA.

            However, Sarah’s deferred annuity also contains a rider guaranteeing to pay her a certain amount per year for the rest of her life. Such a rider has some value, which Sarah must include in valuing the annuity inside the IRA if she does a Roth conversion. The same problem will arise when Sarah must take RMDs. Sarah’s best course of action may be to ask the annuity issuer for help with the valuation because insurers typically have actuaries and software designed to perform these intricate calculations.

            Holding an annuity in an IRA raises many issues that don’t arise with other choices. There may be advantages, but you should proceed cautiously.

Annuity Payback Time

Variations of immediate annuities include the following:

·       Fixed ­period annuities. Here, you receive definite amounts at regular intervals for a specified length of time.

·       Annuities for a single life. These contracts provide you with definite amounts at regular intervals for life. The payments end at your death.

·       Joint and survivor annuities. Usually acquired by a married couple, the first annuitant receives a definite amount at regular intervals for life. After he or she dies, a second annuitant receives a definite amount at regular intervals for life. The amount paid to the second annuitant may or may not differ from the amount paid to the first annuitant.

Making Expense Accounts... Accountable

Business owners who work for their company typically have expense accounts; the same usually is true for many employees. If your company has what the IRS calls an accountable plan, everyone can benefit from the tax treatment. The company gets a full deduction for its outlays (a 50% deduction for most dining and entertainment expenses), while the employee reports no taxable compensation.

            A company expense plan judged to be nonaccountable, on the other hand, won’t be as welcome. It’s true that the company can deduct 100% of the payments it makes for meals and entertainment, but it also will have to pay the employer’s share of payroll taxes (FICA and FUTA) on the expense money paid to employees. The employees, meanwhile, will report those payments as wages, subject to income and payroll taxes.

In that situation, the employee can include employee business expenses (minus 50% of those for meals and entertainment) with other miscellaneous itemized deductions, but only miscellaneous deductions that exceed 2% of adjusted gross income can be subtracted on a tax return. Taxpayers who owe the alternative minimum tax can’t get any benefit from their miscellaneous deductions.

                       

Key factors

In order for expense accounts to get favorable tax treatment, they should pass the following tests:

·       Business purpose. There should be an apparent reason why the company stands to gain from this outlay. An employee might be going out of town to see a customer or a prospect, for example.

·       Verification. Employees should submit a record of their expenses, in order to be reimbursed. Lodging expenses require a receipt, as do other items over $75.

            In order to reduce the effort of dealing with multiple receipts, employers are allowed to give employees predetermined mileage and per diem travel allowances. Substantiation of other elements besides amounts spent (time, place, business purpose) is still required. If the amounts of those allowances don’t exceed the amounts provided to federal employees, the process can be considered an accountable plan. (Excess allowance amounts are taxable wages.) Per diem rates can be found at www.gsa.gov/portal/category/104711.

            Example: XYZ Corp. asks a marketing manager, Jill Matthews, to take a two-day business trip to Atlanta to demonstrate new products. The federal rate for Atlanta (lodging, meals and incidentals) on the federal per diem website is $189 per day. As required by the XYZ accountable plan, Jill accounts for the dates, place, and business purpose of the trip. XYZ reimburses Jill $189 a day ($378 total) for living expenses; her expenses in Atlanta are not more than $189 a day. In this situation, XYZ does not include any of the reimbursement on her Form W-2, and Jill does not deduct the expenses on her tax return.

·       Refunds. Employees must return any amounts that were advanced or reimbursed if they were not spent on substantiated business activities.

·       Timeliness. Substantiation and any required refunds should be made within a reasonable amount of time after the expense was incurred. Those times vary, but IRS publications indicate that substantiation should be made within 60 days, and any employee refunds should be made within 120 days.

            For a plan to be accountable, reimbursements and allowances should be clearly identified. They can be paid to employees in separate checks. Alternatively, expense payments can be combined with wages if the distinction is noted on the check stub. Our office can help you check to see that your company’s employee expense plan is accountable, and, thus, qualifies for the resulting tax treatment.