Q. I’m 67 and I have a small annuity. Is it worth switching it to a Roth IRA at this stage? I still add to the annuity.
— Investor

A. There are several issues that come into play here.

You didn’t say whether this is your only savings or what other kinds of retirement accounts and income you have. For that reason, you should consider meeting with a fee-only financial planner who can review your entire financial situation.

But here are some things to consider.

When it comes to annuities and retirement accounts is it very important to understand the type of account it is and the tax status that applies to it.

Qualified annuities are a type of retirement savings account and pre-tax dollars are typically the source of funds, said Claudia Mott, a certified financial planner with Epona Financial Solutions in Basking Ridge.

“When you contribute to a qualified annuity, you may be able to deduct that contribution on your tax return or it may have been deducted from a paycheck if it is an employer-sponsored plan,” she said. “When the dollars are withdrawn they are taxed as income.”

A traditional IRA is much the same as a qualified annuity in that dollars deposited in the account are often tax-deductible — there are income limits that can affect the deductibility — and the money will grow on a tax-deferred basis until distributions are taken, she said.

A non-qualified annuity also provides tax-sheltered growth of the assets in the account, but contributions are made with after-tax dollars, Mott said.

“When withdrawals are made, the earnings are taxed as income, but the return of the investment you made is not,” she said. “Typically, a distribution payment will be comprised of both return of principal and earnings.”

Similarly, the dollars that are placed in a Roth IRA are considered after-tax and the account will grow on a tax-deferred basis, she said. But the one big difference is that earnings that accrue in a Roth IRA are not taxed. To avoid taxation of earnings, there is a five-year holding period that must be met and the account owner must have reached age 59 ½, she said. There are other exceptions for withdrawals such as a first-time home purchase or expenses related to the birth or adoption of a child.

So what does this all mean?

“A qualified annuity can be rolled over into a traditional IRA, but cannot be directly moved to a Roth IRA due to the difference in the tax-status of the contributions,” Mott said. “If the annuity you hold is a non-qualified vehicle, you would need to cash it out, pay the taxes on the earnings and then deposit the proceeds into the Roth IRA.”

Deciding whether to save your dollars in a Roth IRA or to continue to add to the annuity depends on many factors, two of which would be your income tax bracket and the potential value of the distributions you would receive from both, Mott said.

“If you are in a high tax bracket, adding more to the annuity, which is going to have a portion taxed upon distribution, will diminish the value of those dollars,” she said. “Roth IRAs do not have required distributions and it may be more tax-efficient to allow the money to grow until you need it and save on the taxes when a withdrawal is made.”

Email your questions to Ask@NJMoneyHelp.com.

This story was originally published on March 24, 2021.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.

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