Every now and then the Department of the Treasury and IRS surprise us with taxpayer-friendly legislation that addresses pervasive retirement income planning concerns.
One of the most anxiety-provoking subjects that frighten many people more than death is the possibility of outliving one’s assets. Recognizing this issue, the Department of Labor, the IRS, and the Department of the Treasury began soliciting feedback in early 2010 about the possibility of including advanced-age lifetime-income options in retirement plans. To make a long story short, the Treasury and IRS finalized a regulation in the beginning of July that enables retirement plan participants to invest a portion of their plans in “longevity insurance.”
“Longevity insurance” isn’t an actual product that you can purchase from a life insurance carrier. When you hear this term, it’s referring to a deferred lifetime fixed-income annuity with an advanced age start date, typically 80 to 85. Treasury and IRS are now blessing the use of a specific type of advanced age fixed-income annuity in retirement plans.
Holding deferred fixed-income annuities inside a retirement plan isn’t a new concept. Regulations in effect before the new legislation allow for inclusion of these types of investments without limit provided that the periodic annuity payments satisfy the required minimum distribution, RMD, rules applicable to fixed-income annuities. Specifically, fixed-income annuities are deemed to comply with the RMD rules provided that payments (a) begin by April 1 of the year following the year that the owner turns 70-1/2 and (b) are structured so that they will be completely distributed over the life expectancies of the owner and the owner’s beneficiary.
With the passage of the new tax law, there are six ways that you can longevitize, or extend the financial life of, your retirement.
1. Required minimum distributions can be reduced by up to 25% for up to 15 years
The required minimum distribution, or RMD, rules require you to begin taking minimum annual lifetime distributions beginning by April 1 of the year following the year that you turn 70-1/2. As a result of the new legislation, anyone with defined contribution plans such as 401(k) plans and traditional IRA’s is allowed to circumvent the RMD rules up to the lesser of $125,000 or 25% of their retirement plan balance to the extent that it’s invested in “qualifying longevity annuity contracts” (QLACs). A key, although reasonable, requirement is that QLACs provide that lifetime distributions begin at a specified date no later than age 85.
While it leaves the door open for other types of fixed-income annuities in the future, the legislation limits QLAC investment vehicles to lifetime deferred-income annuities, or DIAs. This shouldn’t be confused with the second type of DIA, i.e., fixed term, which provides for an income stream for a defined number of months or years. The latter doesn’t qualify as a QLAC since, by definition, it doesn’t provide for lifetime income.
2. The lifetime of retirement assets can be extended
To the extent that you carve out a portion of your 401(k) plan or IRA and invest it in a deferred income annuity with lifetime income beginning at an advanced age, you’re extending the life of your retirement assets The easiest way to illustrate this is with an example.
Let’s assume that you’re 71 and you have an IRA with a value of $500,000 on Dec. 31, 2013. In 2014, you would be required to withdraw $18,868 from your IRA. Suppose instead you transferred $125,000 of your IRA to a QLAC in December, 2013, leaving you with a balance of $375,000 in your other IRA assets. Your RMD would be $14,151, or $4,717 less than if you hadn’t invested in a QLAC.
Assuming a 4% annual return for five years and only RMD’s are withdrawn, the balance of the first IRA would be approximately $496,000 at age 76 with an RMD of $22,660. The balance of the second IRA would be approximately $372,000 at age 76 with a RMD of $16,995, or $5,665 less than the original IRA without the QLAC.
3. The lifetime of nonretirement assets can be extended
By reducing the amount of your RMD’s, you also extend the life of your nonretirement assets since your taxable income and associated income tax liability will be less, assuming you’re incurring income tax liability in a particular year. The reduced amount of income can have a ripple effect since higher levels of adjusted gross income reduce otherwise allowable deductions and personal exemptions and potentially increases the 3.8% tax on net investment income on modified adjusted gross income in excess of $200,000 if single and $250,000 for married filing joint taxpayers. In addition, it’s possible that reduced retirement plan distributions may result in reduced taxation of Social Security benefits for individuals in lower income tax brackets.
4. Sustainable lifetime income insures your retirement plan assets
Traditional investment portfolios are exposed to stock market risk and potential withdrawals and, furthermore, aren’t designed to generate guaranteed lifetime income. Fixed income annuities, on the other hand, aren’t exposed to market risk, withdrawals are potentially penalized or prohibited depending upon the type of annuity, and they contractually promise to pay a lifetime income stream (with the exception of a fixed-term DIA) over one or more lives.
Whenever you invest in a lifetime fixed-income annuity, you’re insuring the assets that are being used to make the investment. Specifically, you’re transferring the risk of payment of lifetime income on those assets from yourself to a life insurance company.
5. The value of a portion of retirement plan assets can be insured in the event of death
A qualifying longevity annuity contract, or QLAC, is permitted to have a return of premium feature, or death benefit. The new legislation allows insurance companies to provide for a lump sum death benefit that’s payable to one or more beneficiaries before or after the retirement plan owner’s annuity starting date. The death benefit amount must be equal to the excess of premium payments less the amount of life insurance company payments to the retirement plan owner.
It’s highly advisable that a return of premium feature in the event of death before the annuity start date be included as part of your contract whenever you purchase a deferred income annuity. The trade-off of a slightly lower payout is well worth the peace of mind.
6. Retirement plan assets allocated to fixed-income annuities provide protection against market declines
If you’re within five to 10 years of retirement, you generally don’t want to have all of your retirement assets invested in the stock market. This lesson was unfortunately learned by numerous near-term retirees during the 17-month period between Oct. 1, 2007 and March 6, 2009 when the Dow Jones Industrial Average plummeted 7,600 points, or 54%, from its then record high of 14,088. Allocation of a portion of one’s retirement assets to fixed-income annuities offers protection against such market declines.
Let’s look at an example. Assume that you’re 60 today and you invest $125,000 of your IRA in a QLAC with income beginning at age 80, you will receive lifetime income from an investment of $125,000 with a 20-year deferral period. If, instead, you decide to wait five years to purchase your QLAC, there have been no additions to, or withdrawals from, your IRA, and there’s a 30% decline in the value of your portfolio, you will receive lifetime income from an investment of $87,500 with a 15-year deferral period. Even if interest rates increase in the interim, it doesn’t take an actuary to figure out that the lifetime income from the second scenario will pale in comparison to the first.
Given the fact that people generally underestimate how long they will live combined with the uncertainty of the sustainability of a traditional investment portfolio as a source of retirement income, there’s often the need for a guaranteed lifetime income solution for the latter stage of one’s life. Treasury and IRS’ recent final regulation is an important step toward fulfilling this need and reducing widespread anxiety over the possibility of outliving one’s assets.
Robert Klein is licensed as a Resident Insurance Producer in California (License #0708321).
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.