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 (e.g., Roth 401(k)) – 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 the required minimum distribution. All others are required to take the RMD, but how the benefit is paid depends on how long the account was in force before the owner's death.

Key Takeaways

  • Qualified variable annuities, such as IRAs, are subject to the IRS Required Minimum Distribution (RMD) requirement.
  • At age 70 1/2, qualified account owners are required to begin taking the RMD from their account.
  • ROTH IRAs are not subject to the RMD while the account owner is alive.
  • A 50% penalty on the RMD amount may be assessed if not taken as required.

Effects of Required Distributions

The Internal Revenue Service (IRS) requires owners of IRAs and other qualified retirement accounts to begin taking withdrawals once they reach the age of 70½. The amount of this RMD is determined by an age-based divisor and the balance in the account. A hefty penalty of 50% is imposed if the minimum is not withdrawn each year.

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.