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A Qualified Longevity Annuity Contract (QLAC) is a type of annuity contract specifically designed to keep you from outliving your retirement savings. As a deferred annuity, QLACs provide you with a guaranteed stream of income later in life. In addition, they can help you reduce the retirement account withdrawals mandated by Congress at age 72, helping to defer some income taxes.
How Does a QLAC Work?
A QLAC is a deferred fixed annuity contract sold by life insurance companies that you purchase with money from a retirement savings plan, such as a 401(k), 403(b), 457 Deferred Compensation Plan, or an Individual Retirement Arrangement (IRA).
The qualified part of the name means the annuity has met the requirements set by the IRS for special treatment when purchased with retirement account funds. With most of these arrangements, such as 401(k)s and traditional IRAs, you also get preferential tax treatment — with a requirement that by age 72 you must begin withdrawing a minimum amount of money from the account every year and pay ordinary income tax on those withdrawals. One of your options is that you can invest up to $135,000 of your retirement funds in a QLAC without it counting as a currently taxable withdrawal. You will only pay taxes on that amount when your annuity payments begin.
Longevity alludes to the chief purpose of a QLAC: making sure that you don’t outlive your money. You can buy a QLAC now and put off payments until as late as when you turn age 85.
The annuity contract part of QLAC means you get a guaranteed stream of income. Your QLAC company sends you regular income payments based on the amount you’ve deposited in the annuity, the percentage growth they guarantee, and the date you want to start receiving payments. The longer you defer your income start date, the larger your payments will be.
One important caveat: You can’t purchase QLACs with the assets in a Roth IRA or an Inherited IRA account. Since Roth IRAs don’t require you to start taking RMDs in the first place, there’s no advantage to buying a QLAC using money saved in a Roth IRA.
QLACs and Required Minimum Distributions (RMDs)
With traditional IRAs, and workplace retirement plans like 401(k), 403(b), and 457 Plans, you must begin taking RMD when you turn age 72. These RMDs are taxed at your marginal ordinary income tax rate, and the size of each year’s distribution is calculated by an IRS formula that factors in your account balance at the end of the previous year and your life expectancy.
The big selling point of a QLAC is that your contributions to the annuity reduce the balance in your retirement account used to calculate those RMDs.
Let us presume you have $400,000 in a traditional IRA when you turn 72. According to the IRS formula, your Required Minimum Distribution that year would be your account balance divided by 25.6, for a total distribution of $15,625.
Let’s say you’ve taken 25% of your IRA ($100,000) and invested it in a QLAC, which has no required distributions until you turn 85. Your first RMD at age 72 would now be calculated based on a $300,000 balance, resulting in a distribution of $11,718. That’s a difference of about $3,900—and that means lower income taxes on your conventional RMD. The $100,000 you’ve spent on the QLAC won’t be taxed until you start receiving taxable annuity payments at a later date.
QLAC Contribution Limits
Contributions to a QLAC are limited to the lesser of $135,000 or 25% of your qualified account balance. That means you can contribute up to $135,000 if you have at least $540,000 of qualifying assets and up to 25% of total assets if you have less than $540,000.
For example, if you have an IRA with a balance of $200,000, you can purchase a QLAC for up to $50,000, or 25% of your account balance.
Limits apply depending on what sort of retirement account you are using to fund your QLAC, and the account balances you hold in different retirement plans. Here’s how it works:
• An investor has $270,000 in one IRA and $270,000 in a second IRA. That investor can purchase a QLAC in either account for $135,000 (up to 25% of the total balance of all IRAs).
• An investor has $270,000 in one IRA and $270,000 in a 401(k) account. That investor would be able to purchase a $67,500 QLAC from the IRA account and a $67,500 QLAC from the 401(k) account.
The $135,000 limit on QLAC premiums is a lifetime limit across all funding sources, although the cap may be adjusted by the IRS for inflation. The 25% limit is calculated as follows:
• If you’re funding the QLAC from an IRA, the limit is calculated using the total value of all traditional IRAs you hold as of December 31 of the previous year.
• If you’re funding the QLAC from a 401(k), 403(b) or 457(b) plan, the limit is calculated using the individual plan’s account value on the previous day’s market close.
• If you’ve purchased a QLAC in the past, you should contact a financial professional for help calculating your current 25% limit.
When Should You Begin Collecting QLAC Income?
Choosing a start date for QLAC income payments depends on your current age, health, and financial situation. The longer you defer the start date, the higher your payments will be.
To a certain extent, choosing an income start date depends on how many years you can live on the rest of your savings, and how long you think you’re going to live in general. If you’re 65 and in poor health, you probably don’t want to wait until age 85 to start receiving income payments—and you may not be a good candidate for this sort of annuity at all.
If you have a family history of longevity, then a QLAC may be an appropriate solution to the risk of outliving your savings.
Depending on your life insurance company, you may be able to change the date your payments will start, but only before you’ve started receiving payments.
How a QLAC Can Reduce Your Taxes
A QLAC reduces an investor’s tax burden by protecting a portion of retirement account money from RMD calculations, resulting in smaller required distributions and potentially lower income tax liabilities.
Since they are purchased with pre-tax retirement savings, once you receive income from a QLAC, the distributions are taxable at your current marginal ordinary income tax rate.
What Is a QLAC Cash Refund Death Benefit?
When purchasing a QLAC, you have the option of choosing a plan whose payments stop when you die, a plan whose payments stop when you and your spouse die (joint life QLAC), or a plan that will pay a refund upon your death. In that last case, if there’s any difference between the premium you paid for the plan and the sum of all payments made from the plan, it will be refunded to your named beneficiary.
Choosing a refund death benefit or joint-life QLAC will lower the annual dollar value of QLAC payments you receive.
Why Choose a QLAC?
A QLAC has several advantages for retirees:
• Long-term income security. If you’re worried that your retirement savings might not last for your lifetime, a QLAC can offer you some peace of mind. QLACs provide guaranteed income later in retirement and can act as hedges against long-term care costs later in life.
• RMD deferral. If you’re looking to minimize how much money you’re required to draw from your retirement accounts, a QLAC allows you to delay distributions on a portion of your savings up until you turn 85.
• Principal protection. A QLAC locks in future payments, protecting your retirement money from market crashes, recessions, and depressions, later in life.
• Income for your spouse. If you set up a QLAC as a joint annuity, it will continue paying income as long as you or your spouse is still living.
How to Manage QLAC Risks
QLACs aren’t risk-free, and they have certain tradeoffs. Some advisors, in particular those who are levy management fees on your retirement plan balance (fee-based), especially if they are not licensed to sell life insurance (fee-only), are usually not big fans of QLACs because they can't charge you a fee for the premium you paid to the insurance company. They will argue that QLACs lock-in growth at a low fixed rate, giving up the chance of higher growth using other investment products that they can charge a fee against. This is where the advisors that aren't quite ready for prime time who wax off about "conflicts of interest" get their comeuppance, because now they must face the fact that they, too, have a conflict of interest.
One way to manage the interest rate risk is to ladder your QLACs by purchasing a series of smaller contracts over several years. If interest rates increase, you could receive higher income in the future. Likewise, if interest rates decline, then your future income may be lower in the future.
As with any insurance contract that promises payments in the future, the financial strength of the issuing life insurance company should be your primary concern.
A QLAC is backed by the claims-paying ability of the life insurance company that issued the policy. It is always possible for an insurance company to fail. That’s why it’s important to pay attention to the financial strength ratings of the insurer you’re purchasing the QLAC from. You might also consider purchasing QLACs from more than one life insurance company to spread out the risk.
The Bottom Line on QLACs
QLACs can be a secure addition to your retirement income plan if you’re worried about outliving your savings and if you like the idea of counting on a guaranteed income stream later in life. But this insurance product isn’t for everyone. For more information on QLACs and whether they’re appropriate for your retirement plan, call today (800) 680-5596 or complete the form below:
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