Category: Qualified Longevity Annuity Contract (QLAC)

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Annuities Deferred Income Annuities Qualified Longevity Annuity Contract (QLAC) Retirement Income Planning

Replace Unpredictable RMDs with Secure Lifetime Income

I don’t know about you, however, whenever I’ve been required to do anything, I’ve never looked forward to it. This includes childhood chores like making my bed and mowing the lawn, taking prerequisite courses in college, and satisfying professional continuing education requirements.

It’s not enough that I’ve fulfilled, and continue to fulfill, numerous personal and professional demands. When I turn 70-1/2, I will be subject to yet another obligation that will be enforced for the rest of my life – Congress’ required minimum distribution rules.

Required Minimum Distribution Basics

Assuming that you have one or more retirement plans,  you need to take required minimum distributions (RMDs) from your plans each year beginning no later than April 1st of the year following the year that you turn age 70-1/2. Retirement plans include all employer sponsored plans, including traditional and Roth 401(k) plans, profit-sharing plans, 403(b) plans and 457(b) plans. Traditional IRAs, SEP-IRAs, and SIMPLE IRAs, as well as inherited traditional and Roth IRA accounts, are also subject to the rules.

RMD amounts change each year. They may increase or decrease depending upon two variables:  (a) the value of your retirement plan accounts on December 31st of the prior year, and (b) a life expectancy factor obtained from tables in IRS Publication 590-B. If you fail to withdraw your RMD by the applicable deadline, which is December 31st after the initial year, the amount that hasn’t been withdrawn is subject to an excise tax of 50%.

RMD Example

The main problem with RMDs is lack of predictability of projected annual withdrawal amounts compared to projected retirement income needs. RMDs are dependent upon retirement plan account values which, in addition to contributions, are dependent upon return.

Ignoring future contributions and potential withdrawals before age 70-1/2, let’s assume that you’re 50 years old, single, plan to retire at 67 when you will begin receiving Social Security benefits, and the value of your traditional IRA is $300,000. What will be the amount of your annual RMDs beginning at age 70-1/2? The answer to this question is that it depends upon the underlying investments in your IRA and annual rate of return.

Let’s assume that your traditional IRA appreciates 4% each year for the rest of your life. Per Exhibit 1, the value is projected to increase from $300,000 at age 50 to $684,000 at age 70. RMD’s are projected to increase from $26,000 beginning at age 71, to $35,000 at age 80, and to $44,000 at age 90 at which time they’re projected to level off and begin decreasing.

RMD Alternative

Since you’re planning for retirement and a long lifetime is a possibility, you want to receive a predictable and sustainable lifetime income stream to supplement Social Security while reducing investment risk. You discuss your goals and concerns with your retirement income planner. She recommends that you transfer your traditional IRA into a deferred income annuity (DIA) with a highly-rated life insurance company.

Assuming that you implement your advisor’s recommendation, you will receive monthly lifetime income of $4,059 beginning at age 70-1/2. There are additional guarantees built into your contract, including a return of premium, or investment, in the event that you die before age 70-1/2 and a 10-year certain payout if you die after your payments begin and before age 80-1/2.

Per Exhibit 2, you will receive income distributions totaling just under $49,000 a year from your DIA for the rest of your life beginning at age 70-1/2 in October, 2037. This amount is projected to initially exceed your annual RMD’s by $23,000, declining to an advantage of $13,000 at age 80 and $5,000 at age 89.

Fixed Income Annuities Exempt from RMDs

Fixed income annuities are exempt from RMDs since they have no cash value that can be used in a RMD calculation and the annuity payments are the same each year. Although they’re exempt from RMDs, payments from fixed income annuities held inside retirement plans must begin no later than age 70-1/2.

The income start date of qualified longevity annuity contracts (QLACs), a special kind of DIA designed for non-Roth retirement plan accounts, can be deferred to age 85. QLACs have a maximum allowable investment of 25% of the value of retirement accounts subject to a cap of $125,000.

RMDs vs. Fixed Income Annuity Payments

RMDs may not meet one’s needs since they’re calculated amounts based on fluctuating account values subject to underlying investment values and changing life expectancy factors. Annual calculations must be made and calculated amounts withdrawn by stipulated deadlines to avoid a 50% excise tax.

Fixed income annuity payments, on the other hand, are contractually fixed amounts that can be predetermined years before their start date to cover projected expenses beginning at age 70-1/2. Unlike RMDs, fixed income annuities aren’t subject to investment risk.

Fixed income annuity payments will often be greater than RMDs in early years. Annual differences will be dependent upon retirement plan annual investment returns. While investment accounts can be depleted, fixed income annuity payments will be paid for the remainder of one’s life. Best of all – they’re not required!

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Annuities Deferred Income Annuities Longevity Insurance Qualified Longevity Annuity Contract (QLAC)

Don’t Defer Your QLAC Purchase

Conceptual composition presenting money concern, pliers holds a hundred euro banknote with lifetime title on it.

I was recently asked by CNBC personal finance writer Tom Anderson, who was writing a story on qualified longevity annuity contracts, or QLACs, “What are the biggest mistakes clients make when buying QLACs?” My answer, which was quoted in Tom’s September 9th An Option for Those Who Fear Outliving Their Money article, was not purchasing a QLAC soon enough.

A Special Type of Annuity

QLACs are a special type of deferred income annuity, or DIA, that was approved by IRS in July, 2014. There are four things that distinguish QLACs from DIAs:

  • They can only be held in traditional IRA and retirement plan accounts.
  • They circumvent IRS’ required minimum distribution, or RMD, rules mandating annual age-based withdrawals beginning at age 70-1/2.
  • Lifetime distributions must begin at a specified date no later than age 85.
  • Purchase amount is limited to the lesser of $125,000 or 25% of combined traditional IRA and retirement plan values.

QLACs Aren’t for Everyone

QLACs aren’t for everyone. This is reflected in my quote, “The biggest mistake a client can make when buying a QLAC, assuming the client doesn’t need the income before 75 or so, is not purchasing a QLAC soon enough.”

If you anticipate that you can’t afford to postpone the start date for receiving income from a portion of your retirement plans until 75 or later, then a QLAC doesn’t make sense. You can still purchase a DIA in your traditional IRA or retirement plan, however, your income must begin by age 70-1/2.

Four Decisions

If you would like to carve out a portion of your traditional IRA and retirement plans in exchange for a deferred lifetime income stream, in addition to choosing beneficiaries and the life insurance company from which you will purchase your QLAC, there are four decisions you need to make:

  1. Subject to the investment limitation of the lesser of $125,000 or 25% of traditional IRA and retirement plan values, how much do you want to invest?
  2. Subject to the maximum deferral age of 85, when do you want to begin receiving income?
  3. Which pre- and post-income payout options should you choose, e.g., return of premium (pre-income payout option), life only, life with cash refund, 10-year certain, etc.?
  4. When should you invest?

Purchase Sooner Than Later

What is obvious to most people is the longer you defer your income start date, the greater the amount of your monthly lifetime income. If you begin receiving income at age 85 vs. 75, the insurance company will increase your monthly income significantly since they will be making payments to you for ten less years.

Something that’s not necessarily intuitive for a lot of people is the fact that your monthly payout will also increase if you purchase your QLAC sooner than later.  There’s no minimum purchase age limitation for QLACs.

As an example, assuming that you want your income payout to begin at age 80, your annual payout as a percentage of your investment will be 15% if you purchase at age 70 and will increase to 25% if you do so instead at age 60 with one of the QLACs available from a highly-rated carrier.  Assuming an investment of $125,000, this translates to annual income of approximately $19,000 if you purchase at age 70 vs. $31,000, or $12,000 more, if you do so at age 60.

Subject to availability in individual retirement plans, I would encourage most people who are at least 45 years old and have at least $500,000 in traditional IRAs and retirement plans to transfer $125,000 into a QLAC in order to secure a sustainable lifetime income stream, remove this amount from future stock market volatility, and maximize payout. Additional purchases can be made if IRS increases the QLAC investment limitation.

There’s an important caveat to keep in mind.  Even though your income payment will be slightly less, you should always purchase a QLAC with a pre-income commencement death benefit, or “return of premium” feature. Assuming this is part of your QLAC and you and your spouse, if married, both die before your income start date, your beneficiaries will receive a death benefit equal to your purchase, or premium, amount.

As I was also quoted in the CNBC article, “They (QLACs) will increase in popularity as more carriers offer them. I believe that higher net worth individuals with large IRA balances will gravitate toward them if the current investment limitation of $125,000 is meaningfully increased.”

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Annuities Deferred Income Annuities Income Tax Planning Qualified Longevity Annuity Contract (QLAC)

Is a QLAC Right for You?

2014 marked the introduction of qualified longevity annuity contracts, or QLACs. For those of you not familiar with them, a QLAC is a deferred fixed income annuity designed for use in retirement plans such as 401(k) plans and traditional IRAs (a) that’s limited to an investment of the lesser of $125,000 or 25% of the value of a retirement plan and (b) requires that lifetime distributions begin at a specified date no later than age 85. QLAC investment options are currently limited to deferred income annuities, or DIAs.

The purchase of deferred fixed income annuities in retirement plans for longevity protection isn’t a new concept. What’s unique about QLACs is the ability to extend the start date of required minimum distributions (RMDs) from April 1st of the year following the year that you turn 70-1/2 to up to age 85. This provides potential income tax planning opportunities for QLAC holders subject to the purchase cap.

Potential Income Tax Savings

A lot of individuals are selling QLACs short due to the purchase cap. While on the surface, $125,000 may not represent a sizable portion of a retirement plan with assets of $750,000 or more, the potential lifetime income tax savings can be significant.

The amount of savings is dependent on six factors: (a) amount of QLAC investment (b) age at which QLAC investment is made, (c) deferral period from date of QLAC purchase until income start date, (d) rate of return, (e) income tax bracket, and (f) longevity.

Illustration

I have prepared the attached exhibit to illustrate potential income tax savings achievable by investing $125,000 at three different ages in a QLAC by comparing it to a non-QLAC investment that’s subject to the RMD rules. Assumptions used in the preparation of the exhibit are as follows:

  1. $125,000 is invested in a non-QLAC vehicle at one of three different ages: 55, 60, or 65.
  2. Rate of return is 5%.
  3. RMD’s are taken from age 71 through 85, the range of ages between which RMD’s and QLAC distributions, respectively, are required to begin.
  4. Income tax brackets are 2015 federal income tax brackets plus 5% for assumed state income tax.

In addition to assumed rates of return and income tax brackets, a key assumption is the age at which the QLAC investment is made. All else being equal, purchases at earlier ages avoid greater amounts of RMDs and associated income tax liability. Per the exhibit, the amount of projected income tax savings over 15 years ranges from approximately $20,000 to $97,000 depending upon assumed QLAC investment date and income tax bracket.

Considerations

Reduction of RMDs and associated income tax liability is an important goal, however, it may not be the best strategy for achieving the overriding goal of retirement income planning, i.e., making sure that you have sufficient income to meet your projected expenses for the duration of your retirement.

There are several questions you need to answer to determine the amount, if any, that you should invest in a QLAC:

  • What are your projected federal and state income tax brackets between age 71 and 85?
  • What are the projected rates of return on your retirement funds between 71 and 85 taking into consideration the likelihood of at least one bear market during this time?
  • What is your, and your spouse, if married, projected life expectancy?
  • Which years between age 71 and 85 can you afford to forego receipt of projected net RMD income, i.e., RMD less associated income tax liability?
  • Will you need to take retirement plan distributions in excess of your RMDs, and, if so, in which years and in what amounts?
  • What other sources of income do you have to replace the projected RMD income you won’t be receiving?
  • What is the projected income tax liability you will incur from withdrawing funds from other sources of income?
  • What is the amount of annual lifetime income that you will receive from a QLAC beginning at various ages between 71 and 85 assuming various investment amounts, with and without a death benefit with various payout options?
  • Does it make more sense to invest in a non-QLAC longevity annuity such as a fixed index annuity with an income rider?
  • Should you do a Roth IRA conversion instead?

Given the fact that opportunities to reduce RMDs and associated income tax liability are limited, QLACs are an attractive alternative. Projected income tax savings are just one factor to consider and can vary significantly from situation to situation, depending upon assumptions used. There are a number of other considerations that need to be analyzed before purchasing a QLAC to determine the best strategies for optimizing your retirement income.

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Annuities Deferred Income Annuities Longevity Insurance Qualified Longevity Annuity Contract (QLAC)

QLACs are Here

Since the Treasury and IRS finalized a regulation in the beginning of July blessing the use of qualified longevity annuity contracts, or “QLAC’s,” a lot of people have been wondering when and where they can buy one. Per the last paragraph of my September 15th “Don’t Expect to See QLAC’s Soon” post, speculation was that product launch may begin in the fourth quarter of this year.

The mystery is now behind us. The first QLAC to hit the market was recently released by AIG through American General Life Insurance Co with its American Pathway deferred income annuity. AIG enjoys overall high ratings from independent ratings agencies, including A+, or strong, ratings from Standard & Poor’s and Fitch Ratings, A, or excellent, from A.M. Best Company, and A2, or good, from Moody’s Investors Service.

What’s Different about QLACs?

Subject to their current investment limitation of the lesser of $125,000 or 25% of one’s retirement plan balance, QLACs offer two distinct advantages over other investment vehicles for meeting part of a retiree’s income needs as follows:

  1. A portion of retirement assets exposed to stock market declines can be exchanged for a predictable sustainable lifetime income stream beginning at a specific date up to age 85.
  2. Can defer income taxation of a portion of retirement plan balances for up to 15 years with its exemption from the required minimum distribution, or “RMD,” rules, that otherwise require taking minimum distributions from retirement plans beginning by April 1st of the year following the year that you turn 70-1/2.

Predictable Sustainable Lifetime Income Stream

QLACs are a special type of deferred income annuity, or “DIA.” A DIA is an annuity from which annuitization begins at least 12 months after the date of purchase in exchange for a lump sum or series of periodic payments. The annuitization can be for a term certain or lifetime, depending upon the terms of the annuity contract.

Fixed income annuities, including lifetime DIAs, have previously been allowed to be included in retirement plans provided that payments (a) begin by April 1st of the year following the year that the owner turns 70-1/2 and (b) are structured so that they will be completed distributed over the life expectancies of the owner and the owner’s beneficiary.

QLACs extend the potential income start date of retirement plan assets allocated to them to age 85. In addition to predictable sustainable lifetime income, this enables individuals who have other sources of income to increase the amount of annual income that they will eventually receive from QLAC investments compared to non-QLAC DIAs held in retirement asset accounts.

Circumvent RMD Rules for a Portion of Retirement Plan Assets

Other than converting retirement plan assets to Roth IRAs which often triggers income tax liability at the time of conversion, there has been no other game in town for avoiding the RMD rules prior to QLAC’s. QLAC’s offer an opportunity to defer taxation on up to the lesser of $125,000 or 25% of one’s retirement plan balance at the time of investment.

Depending upon the timing of the QLAC investment and the income start date, the reduction in RMDs and potential income tax savings can be significant. Suppose that you’re 50 and your traditional IRA, which is your only retirement plan, has a value of $600,000. Let’s further assume that you invest $125,000 of your IRA in a QLAC with an income start date of 80.

Had you not invested $125,000 in a QLAC, assuming a 4% rate of return, this portion of your IRA would grow to $273,890 when you turn 70. The first year RMD for this value would be just under $10,000. The income tax savings from not withdrawing this amount of income from your IRA and potential greater amounts for the next ten years could be significant.

QLAC Market

With the release of AIG’s QLAC, the cat is out of the bag. Other insurance carriers are either in the process, or will soon be, requesting regulatory approval for their QLAC offerings. Per my September 15th post, it was, and still is, my personal opinion that widespread availability will not occur until well into 2015. Once this happens and consumers understand and appreciate the two distinct advantages that QLACs offer over other investment vehicles for meeting part of a retiree’s income needs, I believe that demand for this unique product will increase significantly.

Categories
Deferred Income Annuities Longevity Insurance Qualified Longevity Annuity Contract (QLAC) Retirement Income Planning

Don’t Expect to See QLAC’s Soon

One of the most exciting retirement income planning opportunities since the elimination of the Roth IRA conversion income threshold in 2010 has been approved, however, it isn’t available yet for purchase.

For those of you who may not be familiar with the change in Roth IRA conversion eligibility rules, prior to 2010, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA. With the elimination of the income threshold, Roth IRA conversions have soared in popularity since anyone may convert part, or all, of his/her traditional IRA to a Roth IRA. See Year of the Conversion to learn more.

The most recent potential retirement income planning game-changer, qualified longevity annuity contracts, or “QLAC’s,” have received a fair amount of press since the Treasury and IRS finalized a regulation in the beginning of July blessing their use. I have personally written two other articles about them, beginning with 6 Ways a New Tax Law Benefits a Sustainable Retirement published July 25th in the RetireMentors section of MarketWatch and my August 4th Retirement Income Visions™ blog post, You Don’t Have to Wait Until 85 to Receive Your Annuity Payments.

What are QLAC’s?

QLAC’s came about in response to increasing life expectancies and the associated fear of outliving one’s assets. With the passage of IRS’ final regulation, retirement plan participants can now invest up to the lesser of $125,000 or 25% of their retirement plan balance in specially-designated deferred income annuities, or “DIA’s,” that provide that lifetime distributions begin at a specified date no later than age 85. Unlike single premium immediate annuities, or “SPIA’s,” that begin distributing their income immediately after investment, the start date for DIA income payments is deferred for at least 12 months after the date of purchase.

As discussed in my July 25th MarketWatch article, QLAC’s offer a new planning opportunity to longevitize your retirement in six different ways. While longevity is the driving force for QLAC’s, the income tax planning angle, which is the first possibility, has been attracting the lion’s share of media attention. Specifically, QLAC’s provide retirement plan participants with the ability to circumvent the required minimum distribution, or “RMD,” rules for a portion of their retirement plan assets. These rules require individuals to take annual minimum distributions from their retirement plans beginning by April 1st of the year following the year that they turn 70-1/2.

Where Do I Buy a QLAC?

I’ve had several people ask me recently, “Where do I buy a QLAC?” Unlike the Roth IRA conversion opportunity that expanded the availability of an existing planning strategy from a limited audience to anyone who owns a traditional IRA with the elimination of the $100,000 income barrier beginning on a specified date, i.e., January 1, 2010, the implementation of IRS’ QLAC regulation is much more complicated. This is resulting in an unknown introduction date for QLAC offerings.

There are several reasons for this, not the least of which is the nature of the product itself. First and foremost, although an existing product, i.e., a deferred income annuity, or “DIA,” will initially be used as the funding mechanism for QLAC’s, the contracts for DIA’s that are currently available don’t necessarily comply with all of the various provisions of IRS’ new QLAC regulation. While the three mentioned are the most important, i.e., (1) Only available for use in retirement plans, (2) limitation of lesser of $125,000 or 25% of retirement plan balance, and (3) distributions must begin at a specified date no later than age 85, there are other technical requirements that must be met in order for a DIA to be marketed and sold as a QLAC.

In addition to understanding and complying with the nuances of the IRS regulation, life insurance carriers that want to offer QLAC’s are scrambling to restructure existing DIA products and develop new products that will (a) match consumers’ needs, (b) be competitive, and (c) meet profit objectives. This requires a host of system and other internal changes, state insurance department approvals, and coordination with distribution channels, all of which must occur before life insurance companies will receive their first premiums from sales of this product.

Another important obstacle to the introduction of QLAC’s is the fact that fixed income annuities with deferred income start dates, including DIA’s and fixed index annuities, or “FIA’s,” with income riders, are a relatively new product to which many consumers haven’t been exposed. While both products are designed, and are suitable, for use in retirement income plans, most investment advisors don’t currently have the specialized education, licensing, and experience to understand, let alone offer, these solutions to their clients. See What Tools Does Your Financial Advisor Have in His or Her Toolbox?

So when will you be able to purchase QLAC’s? Although current speculation is that product launch may begin in the fourth quarter of this year, it’s my personal opinion that widespread availability will not occur until well into 2015. This will give investment advisers and consumers, alike, additional time to get more educated about fixed income annuities, including their place in retirement income plans. Once the word spreads, I believe that the demand for fixed income annuities will increase significantly, especially if the timing is preceded by a stock market decline.