IRA + VA = Bear Market Protection

This week, Gail explains the reasoning behind the rules governing IRA transfers -- and has an answer for those who wonder if the broker of record on a variable annuity cannot be changed once the contract is annuitized.


Dear Gail-

Two years ago I inherited my grandmother's IRA. It was invested in a variable annuity which had gone down in value before she died because of the stock market sell-off. I don't quite understand why, but I got more than what it was actually worth.

At any rate, I was told by the financial advisor who had worked with my grandmother that I had to start withdrawing money from the account by the end of last year. But he said I could spread out the withdrawals over my life expectancy, which would keep me from having to pay income tax all at once on the whole amount. He also said the easiest thing would be to "annuitize" the IRA, so I did. I liked this guy and did some additional investing on my own with him.

The thing is, I got a new job six months ago and now live 1,200 miles away from my old address. I would like to transfer my accounts so I could work with an advisor in my own area. But he tells me that the tax law says I can't name a new financial advisor for the inherited IRA because it's been "annuitized." Have you heard of this?





Dear Brian,

Up until the comment about not being able to change the broker of record, I'd have to say you were getting good advice.

For the time being, let's forget about what grandma's IRA was invested in. Federal law says that when an IRA owner dies and leaves her IRA to someone who is not a spouse (in your case, a grandson), that beneficiary is required to begin withdrawing at least a minimum amount of money from the IRA every year, generally starting no later than Dec. 31 of the year following the one in which the IRA owner died. The size of the withdrawal depends upon the life expectancy of the beneficiary.

The younger the beneficiary, the smaller the amount they are required to withdraw. That's because each year the so-called "Required Minimum Distribution" is calculated by dividing the IRA value (at the end of the previous year) by the beneficiary's life expectancy. If a 5-year old inherited an IRA, his minimum withdrawal would be found by dividing the IRA balance by roughly 78 -- the number of additional year's a child that age is expected to live. But a 45 year-old would divide the IRA by about 39. Obviously, the larger the divisor, the smaller the amount which must be withdrawn, (You can look up the life expectancy for every age on the Internal Revenue website:

This is what's sometimes called a "stretch" IRA because the life of the IRA is extended beyond the life of the original owner and is "stretched" over a second person's life -- the beneficiary's.

Of course, you are free to take out more than the minimum amount each year or even completely cash out the IRA. However, there's a huge benefit to stretching an inherited IRA: withdrawing just the minimum required each

year leaves most of the assets in the IRA, where they -- and any earnings they could generate -- will continue to be sheltered from income tax. And the beneficiary only has to pay tax on the amount withdrawn.

Here's an example to illustrate the impact of this:

Let's say Blanche dies leaving her $200,000 IRA to her sister, Rita (a non-spouse beneficiary), who is 45 years old. Rita has a choice: she can withdraw all of the money from Blanche's IRA and pay at least of $53,571 in taxes, or she can just take out the minimum amount required annually, based on her 38-year life expectancy, paying tax only on the amount she withdraws each year.

If we assume the investments in the IRA earn 8% each year, "stretching" the withdrawals from Blanche's IRA means that instead of receiving $200,000, Rita could receive as much as $1.25 million over the next 38 years. That, my friends, is the power of tax-deferred compounding. (Keep in mind that this is a hypothetical example and no returns can be guaranteed.)

Now let's take a look at the variable annuity inside your grandmother's IRA.

A variable annuity (VA) essentially consists of investments similar to mutual funds, plus life insurance. Because it is considered a retirement savings vehicle, there is a 10% penalty if you take money out before you're 59 1/2 and assets in a VA have the benefit of growing tax-deferred. Sounds a lot like a traditional IRA, doesn't it?

Which is why some people argue that it doesn't make sense to invest an IRA in a variable annuity: the life insurance component means that, on average, VAs carry slightly higher fees than regular mutual funds. So these folks reason it's not worth it to pay more -- just use plain old mutual funds, instead. However, given what happened in the stock market in the past 3 years, your grandma looks like one smart cookie.

The reason VAs cost more than mutual funds is because you get more. That insurance, for instance. Think of it as bear market protection for your heirs.

Many variable annuities offer what is called a "step-up": when the VA owner dies, the amount the beneficiary receives is guaranteed to be either the amount that was invested (minus any withdrawals), the current value of the account, or what it USED to be worth -- whichever is higher.

Here's how this would work: Say your grandmother invested $50,000 in the variable annuity inside her IRA. Suppose, thanks to the rip-roaring stock market returns we saw in the late 1990s, the value of her VA rose to $75,000. However, due to the recent sell-off in stocks, by the end of last year the value had fallen to $30,000. At that point, Grandma dies, leaving her IRA to you.

How much do you inherit? If the VA has step-up protection, the beneficiary does not receive what the variable annuity is currently worth ($35,000), but $75,000 -- the so-called "highest anniversary value."

Four or five years ago nobody thought the insurance was needed. After all, why pay more for downside protection when stocks seemed to only go up? Today, as we've all learned, we realize they can go down in value, as well. Not all variable annuities offer step-up protection for heirs, so be sure you know which kind you've got. Clearly, your grandmother felt the insurance was worth the cost.

Now, about that "annuitizing" you did. If an IRA is invested in a variable annuity, the simplest and safest way for a beneficiary to "stretch" the withdrawals is to "annuitize" the contract based on your own life expectancy. At this point, you turn over the value of grandma's variable annuity to the insurance company, which guarantees to pay you income for the rest of your life. From then on, the insurance company does all the math, sending you exactly the right amount of money each year to satisfy the "required minimum distribution."

Here's where I start to question the information your grandmother's advisor has given you: According to Amy Floyd, an attorney with Allstate, a major provider of annuity and insurance products, there is NOTHING in the Tax Code which prevents someone from changing the broker of record on an annuity. It makes no difference whether it has been "annuitized" or not.

Furthermore, three other sources in the annuity industry confirm that they have never heard of such a restriction being attached to an variable annuity.

It simply doesn't make sense: what if the financial advisor who originally sold the annuity to the investor retired or died? Does that mean the annuity owner would no longer have ANY advisor to turn to for help? That would be ridiculous because annuities are complex investments! What about a case such as yours where it is simply not geographically practical for you to continue your relationship with the original advisor?

Why would your grandmother's advisor tell you you can't put a different advisor's name on the account as the "broker of record?" Possibly because he receives a fee from the annuity provider for continuing to service this account. If another advisor is named, he'll lose this income.

You have every right to name another advisor on this account. I suggest you contact the insurance company which provides the IRA annuity your grandmother left you. The investor services department can transfer the account to an advisor of your choice who is located near you. It's a simple matter of submitting some paperwork.

Let me know if you have a problem with this,



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