When Does a Roth IRA Make Sense?

Planning for retirement is crucial, but it’s equally important to consider how taxes will impact your income streams and overall expenses. We’ll explore the basics of annuity taxation and discuss strategies for implementing a Roth IRA to help ensure you can enjoy a comfortable and tax-efficient retirement.

Understanding annuities

Annuities are popular financial products that provide a steady income stream, often used as part of retirement planning. One feature that can be added to an annuity is the Guaranteed Lifetime Withdrawal Benefit rider. This rider ensures that the annuity holder receives a guaranteed income for life, regardless of market performance.

This feature ensures that the annuity holder will not outlive their income, even if the annuity’s account balance is depleted.

Learn more about the Ameritas Income 10 Index Annuity with a GLWB rider.

Annuity taxation basics

Annuities offer versatile options for retirement planning and can be set up in various ways. They can be purchased within a traditional IRA, allowing for tax-deferred growth with pre-tax contributions and taxable withdrawals during retirement. Alternatively, annuities can be part of a Roth IRA, where contributions are made with post-tax dollars, enabling tax-free withdrawals and no required minimum distributions. Lastly, non-qualified annuities are funded with after-tax dollars, providing flexibility without contribution limits or required minimum distributions, and only the earnings are taxed upon withdrawal.

Each type offers unique tax advantages and flexibility to suit different financial goals and retirement strategies.

Traditional IRA annuities: All distributions are taxable, and distributions before the age of 59½ may be subject to a 10% penalty.

Roth IRA annuities: After five years, distributions after the age of 59½ are tax-free. This includes GLWB withdrawals in the guaranteed phase when the accumulation value has been depleted.

Non-qualified annuities: After 59½, withdrawals from annuities, including those taken from the GLWB rider, are taken as gains first, subject to ordinary income tax. The cost basis is then taken tax-free until depleted. When the GWLB guaranteed payments continue after the accumulation value has been depleted, payments become taxable again. Payments taken from an annuitized contract have an exclusion ratio that applies a portion of cost basis to each payment, spreading the taxes over the span of the payments.

Retirement implications

A Roth IRA can be an important tool in your retirement planning, particularly when it comes to managing your Medicare costs. For high-income Medicare beneficiaries, the Income-Related Monthly Adjustment Amount (IRMAA) is an additional surcharge added to your standard Medicare Part B (medical insurance) and Part D (prescription drug coverage) premiums. This surcharge is based on your Modified Adjusted Gross Income (MAGI) from two years prior, meaning your income level can directly affect the amount you pay for healthcare in retirement.

If your income exceeds certain thresholds, IRMAA can significantly increase your premiums, potentially adding thousands of dollars to your healthcare costs each year. One way to help mitigate this impact is by strategically managing your taxable income in retirement with Roth IRA withdrawals. Since Roth IRA distributions are not counted in your MAGI, they won’t trigger IRMAA surcharges, allowing you to keep your Medicare premiums lower.

By incorporating Roth IRAs into your retirement strategy, you can not only reduce your future tax bill but also avoid unnecessary increases in healthcare costs, ensuring that more of your retirement savings work for you.

Tax strategy 1: Take advantage of Roth 401(k) options

A Roth 401(k) is an employer-sponsored retirement savings plan that allows you to make contributions with after-tax dollars, resulting in tax-free withdrawals in retirement, provided certain conditions are met. It combines features of a traditional 401(k) and a Roth IRA.

Advantages: Since contributions are made with after-tax dollars, any earnings grow tax-free, and qualified withdrawals (after age 59½ and having the account for at least five years) are not subject to federal income tax.

Disadvantages: Since contributions are made with after-tax dollars, you don’t get an immediate tax break like you would with a traditional 401(k). This can reduce your take-home pay and might be less appealing if you prefer the upfront tax deduction.

Tax strategy 2: Early Roth conversion

Advantages:

• By converting a portion of your IRA to a Roth pre-retirement or in the earliest years of retirement, you have many years to offset the taxes paid with tax-free growth. Using your Roth dollars to purchase an annuity, such as the Ameritas Income 10, can create a tax-free income stream you can’t outlive.
• Any Roth dollars you do not use before your death will be passed to heirs free of income tax.

Disadvantages:

• If taxes aren’t paid from an outside source, they can reduce your balance by the amount of tax due. This leaves the client dependent on strong returns to offset the reduction.
• Depending on your earnings at the time, your total tax could be higher on the conversion than it might have been on a taxable income stream.

Tax strategy 3: Last minute Roth conversion

This strategy involves an annuity with a Guaranteed Living Withdrawal Benefit Rider. When you retire, you take withdrawals from your IRA until the accumulated value of your annuity is greatly reduced but not yet depleted. The taxable amount of the conversion is based on the fair market value of the annuity. This valuation can be complex, so consulting the annuity issuer or a tax professional is advisable. Once the contract is converted into a Roth IRA, the remaining payments continue tax-free until your death.

When you convert to a Roth IRA, you must wait five years before withdrawing earnings tax-free. While contributions can be withdrawn anytime, tax-free and penalty-free, earnings taken out during this five-year period are taxable and may incur a 10% penalty if you’re under age 59½, unless an exception applies. After the five-year period, all withdrawals—both contributions and earnings—are tax-free if you’re 59½ or older. Note that the five-year waiting period applies separately to each Roth conversion.

Advantages:

• By waiting until the accumulated value of the annuity is greatly reduced but not yet depleted, the taxable amount of the conversion is minimized. This strategic timing can significantly lower the upfront tax liability, making the conversion more financially manageable.
• When you convert a traditional IRA to a Roth IRA, the GLWB payments are generally not reduced due to the conversion. The GLWB rider ensures a guaranteed income stream, which typically remains consistent regardless of the account type.

Example:

• A 55-year-old male purchases a $300,000 traditional IRA annuity with a GLWB rider.
• At age 65, the client begins withdrawals of $32,816. These payments are taxed as ordinary income.
• When the client is 78, the accumulated value is $18,344. Currently, the client’s tax bracket is 15%. If the client completes a Roth conversion, the federal tax due would be $2,751. After the conversion, the remaining withdrawals of $32,816 will be tax-free.

A Roth IRA can help you reach your financial goals, especially when considering the tax implications of your retirement income. By strategically planning and using Roth conversions, you can potentially reduce your tax burden, helping ensure a more secure retirement.

Representatives of Ameritas do not provide tax or legal advice. Please consult your tax advisor or attorney regarding your specific situation.

Guarantees are based on the claims-paying ability of the issuing company.

Withdrawals of policy earnings are taxable and, if taken prior to age 59 ½, a 10% penalty tax may also apply.

In approved states, annuities are issued by Ameritas Life Insurance Corp. Policies and riders may vary and may not be available in all states. Optional riders may have limitations, restrictions and additional charges.

This information is provided by Ameritas®, which is a marketing name for subsidiaries of Ameritas Mutual Holding Company. Subsidiaries include Ameritas Life Insurance Corp. in Lincoln, Nebraska and Ameritas Life Insurance Corp. of New York (licensed in New York) in White Plains, New York. Each company is solely responsible for its own financial condition and contractual obligations. For more information about Ameritas®, visit ameritas.com.

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