Worried about taxes on huge RMDs? Consider this alternative to Roth conversions.

If you have a large IRA balance, an annuity might help you diversify the savings. - Getty Images/iStockphoto

The sweet spot for doing Roth conversions is before you start taking out the required minimum distributions (RMDs) so the government can start to get its cut of the money you’d been deferring from taxes for decades. Once you turn 73, it’s usually game over. There’s a new role for annuities at this stage, given a change in the Secure 2.0 Act and the current interest-rate environment.

People often cringe at any mention of annuities because they are complicated and usually come with a sales pitch. But there are circumstances where they might make sense, and one of those is when a person with a large IRA balance turns 73 and doesn’t really need the money they must withdraw for living expenses, perhaps because they have a pension or other savings. They’d rather not incur all this income that goes on their tax return, increasing the taxable portion of their Social Security, throwing them into the IRMAA surcharges on their Medicare premiums and saddling them with future capital-gains growth when the money then transfers to a taxable investment account.

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This is the issue that Roth conversions seek to address, but people often run out of time. Once you start taking RMDs, you have to withdraw those first and pay the tax. Added to Social Security and other investment income, it’s easy enough to fill up the lower tax brackets to the top of the 22% or 24% brackets, and then it does not make sense to add a Roth conversion on top of that at the 32% or 35% bracket. You want to do Roth conversions when your current tax rate is lower than your more likely future tax rate.

What makes an annuity potentially work in this scenario is that Secure 2.0 made it possible for the annuity payments to cover for any other RMDs from IRAs. It won’t work for everyone, especially those looking to closely control their yearly income for tax-bracket management, but it could work for some who want to lower RMDs without doing Roth conversions.

To keep things simple, think about an IRA account with a $1 million balance when the owner turns 73. The RMD would be roughly 4%, or about $37,000 on the whole balance. If the person purchased a $300,000 single premium immediate annuity, the RMD would be $11,000 on the annuity and $26,000 on the $700,000 balance in the IRA. If that annuity yielded $2,000 per month — via Fidelity’s Guaranteed Income estimator — there would be $13,000 left over to count toward the RMD in the rest of the account, and the person would only have to withdraw $13,000. The combined $37,000 would be the income for the year.

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“The way that IRS aggregation rules work is that all IRAs get lumped into the same bucket. It could be one account and 12 annuities. So if that annuity is already paying out more, it can count for other accounts as well,” said Steven Jarvis, a CPA who runs Retirement Tax Services.

It comes out relatively even for the first year, but what happens next is the whole point. Those with large IRA balances that they don’t need right away aren’t necessarily worried about the withdrawals right away — it’s the potential growth that leads to the nickname of the “tax time bomb.” If you take out only the RMD, you never get ahead of growth, and the account balance keeps climbing — as does the amount you have to take out with the RMD formula. In 10 years, your $1 million account balance might be $1.3 million, and the RMD is $72,000. And in 20 years, the balance would be roughly the same, but the RMD is now $123,000.

If the person dies at 93, then a non-spouse inheritor has a balance of $1.3 million that they have to withdraw by the end of 10 years, paying tax on distributions. A spouse who inherits would just keep to the schedule and push the problem forward until they died.

A single premium immediate annuity, the simplest of annuity products, would not grow in the same way, but would decline steadily as the payments came out. The second year, it might be down to $289,000, and so forth down the line. The $700,000 remaining in the IRA would continue to grow, but more slowly because of the lower balance. After 10 years of only taking the minimums, the annuity might be valued at $180,000, and the rest of the IRA at $894,000. The monthly annuity payments, still being $2,000, would now cover a larger portion of the IRA’s RMD, so could help control the level of taxable income. Your overall IRA balance would be just over $1 million, versus $1.3 million.

“That’s not a bad gig if you’re looking to get ahead of it,” said Shawn Plummer, chief executive of the Annuity Expert, an online insurance firm.

Another annuity to consider would be a qualified longevity annuity contract (QLAC), which pushes forward an annuity of up to $210,000 until the person is 85. It removes that portion of the account from the RMD calculation for the time period before the annuity payments start.

“So many people are afraid they’re not going to live that long, but if you have longevity in the family, you need to think about that,” said Barbara Pietrangelo, a certified financial planner with Prudential. “My oldest client just died at 104, and she had an annuity, it was a great deal.”

Still another layer to add to this strategy is to use qualified charitable distributions (QCDs) to cover for the excess portion of the RMD that’s not covered by the annuity payment, if the person is charitably inclined. It’s a way to get tax savings on money you were going to give to charity anyway, but routed through the IRA after age 73, it reduces your taxable income for the year in a way that is usually not captured by the rest of the tax return, since most people don’t itemize.

In combination with the new bonus senior deduction for the next several years, that would allow a wealthy retiree more flexibility. For those with lower IRA balances, it would not make much of a difference, because they are likely withdrawing more than their RMD for everyday expenses anyway, but it is not impacting their tax brackets. For instance, if you have an IRA balance of $250,000, your RMD at age 73 is $9,400, so if you take $1,000 a month for expenses, you’re still taking more. The highest the RMD ever gets on the balance, assuming 7% growth and only minimum distributions, is about $35,000, and that is at age 98, according to AARP’s calculator.

What you get with an annuity

Annuities are still a hard sell for most people. Yes, there are fees involved. Yes, you have to talk to a salesperson to generate the contract and they might try to upsell you to more complicated options. But conditions are good right now for guaranteed returns based on current interest rates, and an annuity helps create an income stream to replace steady pay in retirement.

“I try to make sure my client has a paycheck to cover basic bills, and some of the annuities have some really nice payout rates, depending on the health and financial situation of the person to figure out what’s best,” said Prudential’s Pietrangelo.

If you consider an annuity as part of your fixed-income allocation, you might find a better return on your investment this way than in Treasury products, CDs, or corporate and municipal bonds. And, of course, since we’re talking about this as a strategy for large IRA balances, you might be wealthy enough to do all of the above. Diversification in retirement is good, and having an annuity alongside other fixed-income investments, as well as equity investments, is a plan.

To think more deeply about diversification, you want to consider your best option for which funds to use for an annuity. This is also an either/or situation. Some people have multiple annuities. A qualified annuity can help you with your RMD situation when Roth conversions no longer make sense. An annuity within your Roth IRA could help you control your income for the year, since any proceeds would not be taxable income.

“It’s about doing a plan for the client, and figuring out their situation. A lot of time the answer is ‘all of the above,’” said Pietrangelo.

Got a question about investing, how it fits into your overall financial plan and what strategies can help you make the most out of your money? You can write to me at . Please put “Fix My Portfolio” in the subject line.

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