An annuity rollover is a complex financial transaction that should be undertaken very carefully, and there are many considerations of which the consumer should be aware. The most easily preventable problems arising from annuity rollovers are those caused by inattention to the details. Paperwork must be meticulously prepared, and the consumer must never take possession of the funds; the financial institutions involved should conduct the transaction between themselves for the benefit of the annuity owner, who should never handle the funds, not even to sign over a check. This should prevent dramatic and traumatic adverse tax consequences.
In the United States, the term “rollover” refers to the shifting of funds from one type of investment to another that’s similar in nature, as defined by the Internal Revenue Service (IRS). Most rollovers in the United States are given preferential tax treatment, postponing federal taxes due until the maturation or payout of the new investment. In general, the transfer of funds from a tax-qualified investment to a non-qualified investment, or vice-versa, isn’t considered a rollover.
There are two types of transactions that could be considered an annuity rollover. The first, and most common, is the rolling over of funds accumulated in a tax-qualified retirement account like an IRA, a 401(k) or a 403(b) into an annuity. This type of rollover generally takes place upon retirement or separation from employment with an organization sponsoring the retirement fund, whether 401(k) or 403(b). The second type of annuity rollover, which is far less common, involves moving funds from an annuity to another type of investment, such as an IRA or another annuity.
Consumers rolling over funds into an annuity must be aware that they’re locking their money up for a significant period of time, usually no fewer than five years and often as many as 15. While it’s usually possible to withdraw a portion — up to 10% or so — without incurring any penalty, the penalties imposed on withdrawals beyond that amount can be severe, reaching as high as 15% or more of the amount withdrawn, depending on the annuity's age. Thus, whatever funds are rolled over into an annuity should be funds that aren’t necessary in the near term.
The two most common reasons for rolling money over into annuities is safe growth of funds with no possibility of loss and the establishment of guaranteed lifetime income stream. When retirement funds are involved, the reason is sometimes a combination of the two — an annuity rollover is intended first to be a way of letting retirement funds grow, following which the annuity is annuitized, or converted into that guaranteed lifetime income stream. There’s no time requirement for annuitizing; it can be done at the time of purchase, the day after purchase, or years later.
Upon annuitization, the lump sum is no longer available. The owner no longer controls it and can no longer withdraw from it, because it's no longer the owner's property. The lifetime income stream guarantees that the owner, who is now the annuitant, will never outgrow his money, no matter how much the insurance company ultimately pays out. There always exists the possibility that the annuitant may die before the annuity’s funds are exhausted, however. The “period certain” option is available to counter such concerns, so that the balance of an annuity continues to be paid out even after the annuitant’s death. At any rate, less than 15% of all annuities are ever annuitized.
Some annuities carry significant costs, fees and penalties, but comparison shopping should help consumers to identify insurance companies whose annuities carry low fees, or none at all. They should especially try to avoid companies that charge them for sales commissions paid to agents. In addition, prudent consumers should investigate bonuses carefully. Many companies offer valid bonuses to induce purchase of their annuities, but some insurance companies deceptively offer bonuses that are only implemented upon annuitization. Consumers who liquidate their annuities in the future won’t benefit at all from such bonuses.
Another feature of annuities is that they generally bypass probate, avoiding estate taxes and being immediately payable to the beneficiaries. There is a downside, though. When an annuity is paid as a lump sum to a beneficiary upon the owner’s death, gains on unqualified annuities, and the entire amount of qualified annuities, generally become taxable as ordinary income to the beneficiary.
Finally, consumers considering an annuity rollover as part of a retirement strategy should also be aware that while annuities in general guarantee against loss, that’s not the case with most variable annuities. With this type of annuity, the principal and interest both are always at risk of being reduced or eliminated due to market losses.