401(k) Rollover to an Annuity: Rules, Steps, and What Changes

A 401(k) is a savings account with investment choices; it has no built-in way to turn a balance into a paycheck that lasts for life, and no way to lock a guaranteed interest rate for several years. An annuity does both. The common reasons for a rollover are a guaranteed rate for a set term through a multi year guaranteed annuity, principal protection with index-linked growth through a fixed index annuity, or lifetime income through an immediate or deferred income annuity.

The rollover itself changes nothing about taxes. Money that was pre-tax in the plan stays pre-tax inside the IRA annuity, and every dollar that comes out later is ordinary income. What the rollover adds is the insurance guarantee; what it costs is the annuity's surrender schedule and, for some contracts, rider fees. The decision is really about whether you want part of the balance to behave like a pension.

Takeaway: An annuity in an IRA is a product inside an account. The tax rules come from the account; the guarantees come from the product.

Federal law lets a plan distribute your balance, and therefore lets you roll it, after you separate from service, when the plan terminates, or when you reach an age the plan sets for in-service withdrawals. Most plans use 59 and a half for in-service withdrawals of your own deferrals; some allow earlier in-service rollovers of rollover money or employer contributions. The plan document controls, so the first call is to the plan administrator, not the insurer.

Money you leave in the plan after separating keeps its plan protections. If you separated from service in or after the year you turned 55, the plan can pay you without the 10% early distribution penalty; an IRA cannot, until 59 and a half. Employer stock with a low cost basis can be distributed in kind with net unrealized appreciation taxed later at capital gains rates; once it is rolled into an IRA that treatment is gone. Neither point is a reason not to buy an annuity, but both are reasons to roll only the portion you intend to annuitize or lock in a rate for.

A direct rollover sends the money from the plan to the IRA custodian that holds your annuity, either by wire or by a check made payable to the new custodian for your benefit. Nothing is withheld, nothing is reported as income, and there is no deadline once the plan releases the funds. This is the way an annuity rollover should be done.

An indirect rollover pays the distribution to you. The plan must withhold 20% for federal tax, and you have 60 days to deposit the full pre-withholding amount into the IRA. To complete the rollover you have to replace the withheld 20% from other savings; whatever you fail to redeposit is taxed as income and, before 59 and a half, hit with the 10% penalty. You recover the withholding when you file your return, but only if you fronted the money in time.

The once-per-12-months rule on indirect rollovers applies to IRA-to-IRA rollovers, not to a rollover from a workplace plan to an IRA. Even so, a second indirect rollover from one IRA annuity to another within a year would be treated as a taxable distribution, which is one more reason to move retirement money only by direct transfer. (A Section 1035 exchange is the tax-free route between non-qualified annuities, the kind bought with after-tax savings. Money in an IRA annuity moves by trustee-to-trustee transfer instead.)

Takeaway: Ask the plan for a direct rollover to the IRA custodian named on the annuity application. If a check arrives made out to you personally, call before you deposit it.

When rollover money buys an annuity, the insurer sets the contract up as an IRA, or your IRA custodian buys the contract as one of the IRA's holdings. Either way it is a qualified annuity. The account was already tax-deferred, so the annuity adds no second layer of deferral; the tax deferral people associate with annuities only matters for non-qualified money bought with after-tax savings.

Required minimum distributions apply to the IRA annuity the same way they apply to any traditional IRA. Under current IRS rules the first RMD is due for the year you turn 73, and the starting age is scheduled to rise to 75 for people born in 1960 or later. For a deferred annuity the insurer reports a year-end value, adjusted for certain guaranteed riders, and that value goes into the RMD calculation. Once a contract is annuitized, the annuity payments themselves generally satisfy the RMD for that contract, and the IRS now allows the annuitized contract to be aggregated with your other IRAs when figuring the total.

Surrender charges do not stop an RMD. Most contracts let you take the RMD amount free of surrender charges even if it exceeds the usual free withdrawal allowance, but confirm that in the contract before you sign, especially on a long surrender schedule.

The SECURE Act made it easier for 401(k) plans to offer annuities. Plan sponsors got a safe harbor for selecting an insurer, participants must now receive an annual estimate of the lifetime income their balance could produce, and an annuity held inside a plan can be moved to an IRA if the plan later drops it, without the surrender charges a forced liquidation would trigger. If your plan offers a guaranteed income option, compare its price and guarantees to a rollover annuity before assuming one is better.

A qualified longevity annuity contract is a deferred income annuity bought with IRA or 401(k) money under special IRS rules. The premium, up to the IRS dollar limit that is indexed each year, is removed from the balance used to calculate your RMDs, and payments must begin no later than age 85. It is the one way to use retirement money to buy income that starts in your 80s while shrinking the RMDs in between.

Rolling the whole balance into one annuity concentrates your retirement savings in a single contract, a single insurer, and a single surrender schedule. It also gives up the plan's liquidity and its federal creditor protection under ERISA, which is stronger than the protection an IRA gets under state law. Rolling part keeps the rest invested and accessible while the annuity does the one job it is good at.

A common approach is to size the annuity to the income gap: the essential expenses that Social Security and any pension do not already cover. Money for that gap goes into guaranteed income; the rest stays in the plan or a rollover IRA with normal investments. For a rate-lock strategy, the size is whatever you would otherwise have put in a certificate of deposit or a bond for the same term.

• Roll part when you want guaranteed income for essentials, a rate lock for a defined sum, or principal protection for the years right around retirement.
• Keep money in the plan when you separated at 55 or later and may need it before 59 and a half, when you hold appreciated employer stock, or when the plan's fees are low and its creditor protection matters to you.
• Never roll into a single contract whose surrender period is longer than your realistic need for the money.

The mechanics take a few weeks and go smoothly when the paperwork is set up in the right order.

• Confirm with the plan administrator that you are eligible to take a distribution and ask for the direct rollover form.
• Choose the annuity type and term with a licensed specialist, and read the surrender schedule and any rider fees before applying.
• Complete the annuity application as an IRA (traditional, or Roth if the plan money is Roth 401(k) money), naming beneficiaries.
• Have the insurer or IRA custodian generate the transfer request; the plan sends the money directly to them.
• Verify the deposit and the contract's free-look period, and keep the plan's 1099-R and the IRA's Form 5498 for your records.
• Calendar your RMD start year and confirm how the contract handles RMD withdrawals during the surrender period.

A 403(b) is the nonprofit and public school version of a 401(k), and many are already invested in annuity contracts, historically called tax sheltered annuities. The rollover rules are the same: a direct rollover to an IRA annuity is tax-free after separation or at the plan's in-service age, and the money stays qualified.

The Thrift Savings Plan for federal employees and service members offers its own life annuity option through a single insurer, purchased directly from your TSP balance, alongside installment payments and partial withdrawals. You can also roll TSP money to an IRA and buy any insurer's annuity there. Compare the TSP annuity's payout options and rates against outside quotes for the same premium and age before choosing; the right answer depends on the numbers at the time, which change with interest rates.

Governmental 457(b) plans roll the same way and have one extra feature: 457(b) money withdrawn from the plan after separation is never subject to the 10% early distribution penalty at any age, a benefit that is lost once the money is rolled into an IRA.