Can You Roll Over a Pension Into an Annuity?
Transferring a pension to an annuity depends on your plan's specific payout options and the rules for maintaining the funds' tax-deferred status.
A common question for those approaching retirement is whether it is possible to roll over funds from a pension plan into an annuity. This transaction allows you to customize retirement income, potentially gaining features or payout structures not available within your original pension plan. The ability to perform such a rollover depends on the specific type of pension and the options it provides.
Understanding Your Pension Payout Options
The ability to move pension funds into an annuity depends on your retirement plan’s structure. Pensions are categorized into two types: defined benefit (DB) and defined contribution (DC). A DB plan, or traditional pension, promises a specific monthly payment for life based on salary and service years and does not have an individual account balance.
A rollover from a DB plan is only possible if the plan offers a lump-sum payout option. This allows a participant to receive the total value of their future pension payments in a single distribution instead of monthly checks. Companies may offer these buyouts to reduce their long-term pension liabilities.
Defined contribution plans, such as 401(k)s and 403(b)s, are more straightforward. These plans maintain an individual account balance for each employee based on contributions and investment growth. Because the funds are held as a portable sum, they are eligible for a rollover into an annuity upon separation from service.
Key Information for an Annuity Rollover
Annuities are insurance contracts that provide regular payments. A fixed annuity offers a guaranteed, unchanging payment amount. A variable annuity allows the owner to invest the principal in sub-accounts, so future income can fluctuate with market performance. A fixed-indexed annuity links its interest to a market index, offering growth potential with a guaranteed minimum return.
A rollover from a qualified pension plan to a qualified annuity is a non-taxable event if executed correctly. This transfer preserves the tax-deferred status of the savings, so no income tax is due at the time of the move. The funds continue to grow tax-deferred within the annuity until withdrawn.
To prepare for this process, you will need documentation from your pension plan administrator. This includes a statement detailing the lump-sum value of your benefit and the required rollover distribution forms.
The Rollover Process
The most common method is a direct rollover, or trustee-to-trustee transfer. The funds are sent directly from your pension plan administrator to the financial institution issuing the new annuity. You never take possession of the money, which avoids potential tax complications.
An alternative is the indirect rollover, where the plan administrator issues a check to you. You have 60 days from receipt to deposit the funds into the new annuity. If you miss the deadline, the distribution becomes taxable income, and a 10% early withdrawal penalty may apply if you are under age 59½. For indirect rollovers, the administrator must withhold 20% for federal taxes, which you must replace with your own funds to complete the full rollover.
The process involves several steps:
- Select an annuity provider and complete their application to open an account.
- Formally request a distribution from your pension administrator by submitting their rollover paperwork.
- Specify on the form whether you are choosing a direct or indirect rollover.
- Expect confirmation from both providers once the transfer is complete, which can take several weeks.
Post-Rollover Tax Treatment
The tax treatment of income from your new annuity is determined by the tax status of the funds used to purchase it. If your pension was funded with pre-tax contributions, as is common with 401(k)s, the rules are straightforward. Every dollar you receive in annuity payments will be fully taxable as ordinary income at your federal and state tax rates.
If your pension contained after-tax contributions, the tax situation is different. A portion of each annuity payment is a tax-free return of your principal, while the rest is taxable earnings. The IRS uses an exclusion ratio to determine the non-taxable portion, calculated by dividing your total after-tax investment by the total expected payments.
For example, if you made $20,000 in after-tax contributions and your total expected return is $200,000, then 10% of each payment would be tax-free. The remaining 90% would be taxed as ordinary income. This treatment continues until you have recovered your after-tax contributions, after which all payments become fully taxable.