It has always been fascinating to me how income-tax laws motivate behavior. Take IRAs for example. Even though the contribution limit is only $5,500, or $6,500 if you’re 50 or older, traditional and Roth IRA contributions continue to be the go-to choice for many individuals planning for retirement.
Limited tax savings with QLACs
Although it’s early in the game since they were introduced less than two years ago, purchases of qualified longevity annuity contracts, or QLACs, have been, and will continue to be, tax motivated in many cases. 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.
Unlike other types of retirement plans where required minimum distributions, or RMDs, must begin by age 70½ in most cases, income distributions can be delayed up to age 85. Purchases of QLACs are limited to the lesser of $125,000 or 25% of the total value of a particular type of retirement plan, e.g., traditional IRA accounts, 401(k) plan, etc. QLACs cannot be purchased with Roth or Inherited IRA funds.
While the ability to defer RMDs has been the primary marketing strategy used by life-insurance carriers to date to promote QLACs, income-tax savings generally won’t be substantial given the relatively low cap on the investment amount. Income-tax savings will also be reduced to the extent that QLACs are purchased close to age 70, payouts begin before age 80, or income tax brackets are low.
Longevity protection is key
All retirement-plan investments other than fixed-income annuities are subject to the risk of premature depletion. Withdrawals and poor investment performance often result in exhaustion of retirement assets.
A QLAC is a special type of deferred income annuity, or DIA. DIAs provide longevity protection in the form of a term or lifetime income payout to one or more individuals. QLACs are designed to generate a lifetime payout.
Like all DIAs, the income start date for a QLAC begins at a specified date at least 12 months after the date of purchase, with 85 being the maximum allowable starting age. While the amount of the payout is generally fixed unless an optional inflation factor is added to the contract, it will continue for life.
No IRS-imposed limits on non-QLAC fixed income annuity purchases
Unlike QLACs, there are no IRS-imposed limits on DIAs and other types of fixed-income annuity purchases. This includes retirement and nonretirement single premium immediate annuities, or SPIAs, and fixed index annuities, or FIAs, with income riders. This is an important consideration for individuals who are concerned about the possibility of outliving their assets and/or who are seeking the security of a monthly lifetime income stream.
In addition to longevity protection, nonretirement DIAs provide their owners with another important advantage not offered by other types of investments. The income stream is subject to an exclusion ratio whereby a portion of the payments is considered to be a return of principal, and, as such, is nontaxable.
Ideal retirement-income planning tool
Fixed-income annuities are a unique and, furthermore, ideal retirement-income planning tool since they can be customized to dovetail with projected after-tax, inflation-adjusted retirement-income needs at different stages of retirement. Annuity types, location (i.e., nonretirement or retirement), purchase amounts, and income start dates can be optimized to match projected non-discretionary and discretionary spending needs.
QLACs are limited in their ability to generate the security of a lifetime income stream that can match retirement-income needs due to the cap on the investment amount, their advanced age income start date, and the fact that they can only be used in retirement plans, distributions from which are fully taxable as ordinary income. If you don’t want to limit your longevity protection to $125,000 and you want a plan that’s customized to your needs, you need to explore other types of fixed-income annuities.
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.