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.
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:
- $125,000 is invested in a non-QLAC vehicle at one of three different ages: 55, 60, or 65.
- Rate of return is 5%.
- 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.
- 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.
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.
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.