Q&A: Tax consequences of annuity conversion

Dear Liz: Several years ago my wife inherited an IRA when her mother died. Her banker suggested rolling the IRA into an annuity with an insurance company. That company is difficult to deal with and not forthcoming about how the annuity is invested. She wants to convert the IRA into a certificate of deposit so it is insured by the FDIC. What are the tax consequences of doing that?

Answer: There are many different types of annuities. If your wife purchased an immediate annuity, which offers a stream of payments in return for a lump sum, then she probably can’t change her mind since those transactions are effectively irreversible.

If she purchased a deferred annuity, though, she has more options. Deferred annuities allow people to defer the stream of payments until later — often years or even decades in the future. In the meantime, the annuity may pay a fixed rate, a variable rate based on the performance of underlying investments, or an indexed rate based on a market benchmark.

Your wife won’t face taxes if she switches from a deferred annuity to a CD, since changing investments within an IRA isn’t considered a taxable event. The annuity itself may have surrender charges, however. Because annuities often pay advisors substantial commissions, surrender charges help discourage investors from withdrawing the money before insurers can recoup those fees.

These charges and high expenses in general make deferred annuities a poor fit for many investors, and many financial planners especially dislike seeing them in IRAs. A deferred annuity’s primary advantage is tax deferral, which an IRA already offers.

If your wife feels she was misled about this investment, she can make a complaint with her state insurance regulator.

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