Annuities Deferred Income Annuities Income Tax Planning Long-Term Care Longevity Insurance Retirement Income Planning

The Perfect Storm for a Tax Credit Longevity Annuity Plan

A Tax Credit Longevity Annuity Plan, or TCLAP, would create tax-favored private pension plans while also providing for long-term care benefits.

With momentum building for tax reform, concerns about the long-term sustainability of Social Security, widespread lack of long-term care protection planning, and the failure of 401(k) plans to replace private pension plans that were once a cornerstone of our parents’ and grandparents’ retirement income, we have the perfect storm for Congress to introduce, and the President to sign, Tax Credit Longevity Annuity Plan legislation.

Similar to a qualifying longevity annuity contract, or QLAC, which was enacted in 2014, a Tax Credit Longevity Annuity Plan, or TCLAP, (my creation) would use one or more deferred income annuities, or DIAs, offered by life insurance companies as its chassis.

Deferred Income Annuity Advantages

DIAs offer three advantages over traditional savings vehicles which make them attractive as the foundation of a comprehensive retirement income planning strategy:

While payment options include a fixed term or lifetime, most people opt for the latter. When you purchase a DIA, you choose a deferred income start date. Once payments begin, they continue for the life of the annuitant and a joint annuitant if applicable assuming a lifetime payment option is chosen.

  • Locked-in savings plan

A DIA is irrevocable. Unlike traditional retirement savings plans from which funds can be withdrawn before retirement resulting in premature depletion, you enter into a contractual relationship with a life insurance company when you purchase a DIA. The contract provides that you will receive a defined monthly income beginning on a specified future date in exchange for a specified premium. Unless there’s a return of premium provision included in your contract, your premium is nonrefundable.

Subject to the claims-paying ability of individual life insurance companies, funds allocated to DIAs are protected against stock market declines. Individuals who purchase DIAs will receive a contractually-fixed amount of lifetime income beginning on a certain date even if there’s a major stock market correction.

12 Proposed Provisions

A Tax Credit Longevity Annuity Plan, or TCLAP, if enacted, would expand upon, and overcome, various shortcomings associated with QLACs. Periodic income payments would be similar to comparable non-TCLAP DIAs. There would be 12 proposed provisions as follows:

1.  Nonqualified Investment

Most people associate retirement planning with investing in qualified retirement plans such as 401(k)s and IRAs. To the extent that you make deductible contributions to these types of plans, 100% of your distributions will eventually be taxable. This wouldn’t be so bad if you invested the tax savings from your deductible contributions and used them for retirement, however, most people don’t do this.

Unlike a QLAC which can only be used inside retirement plans, the source of TCLAP investments would be nonqualified funds. Although income payments would still be taxable, a sizable portion would be exempt from taxation. This is due to the fact that an “exclusion ratio” is applied to nonqualified DIA distributions.

An exclusion ratio reduces the amount of taxable DIA distributions by the portion of each distribution that’s deemed to be a return of investment. The ratio is equal to your investment in the contract divided by your expected return based on your actuarial life expectancy at the age that you begin receiving distributions.

Approximately 25% to 65% of each income payment can be excluded from taxation depending upon your age when you begin receiving your distributions. The percentage that’s initially used will continue until you reach your actuarial life expectancy and your cumulative payments equal your total investment in your contract. 100% of future payments are taxable once this occurs.

2.  Additional Premiums

While several DIAs allow for subsequent investments in future years, there are several that limit investment to a single premium. Given the fact that the purpose of a TCLAP would be to meet sustainable income needs not fulfilled by other sources such as Social Security, a single premium would generally be insufficient.

Given this reality, a TCLAP carrier would accept initial and subsequent premiums up to a specified period, e.g., two years, prior to the income start date.

3.  Investment Tax Credit for Initial and Subsequent Investments

One of the most compelling ways to incentivize behavior is with tax credits. A tax credit, unlike a tax deduction which is dependent upon one’s marginal tax bracket for determining the amount of tax savings, is a direct offset to tax liability. Most tax credits today, with the exception of residential energy and credits for all-electric and plug-in hybrid vehicles, the latter of which can be as much as $7,500, are subject to income limitations.

Assuming that the purpose of tax reform is to benefit the middle class, the long-term sustainability of Social Security is questionable, and Congress wants to encourage and promote self-funded private pension plans, an investment tax credit equal to a percentage of initial and subsequent investments makes sense. The percentage would be modest to compensate for the fact that a sizable portion of income distributions will be nontaxable.

In order to encourage individuals to direct a high level of their savings into TCLAPs beginning at an early age to produce a significant amount of sustainable income to pay for their retirement expenses, I would recommend that Congress support a tax credit equal to 8% of initial and subsequent investments for individuals who aren’t qualified retirement plan participants and 4% for those who are. This would go a long way toward subsidizing investment in TCLAPs that wouldn’t otherwise be made in most cases.

4.  Annual and Lifetime Investment Limitation

Given the fact that a sizable investment in a fixed income annuity such as a DIA is required in order to receive a meaningful amount of income, there should be a reasonably high limit on the amount of allowable initial and subsequent investments in TCLAPs.

I would propose a limit of $100,000 in the initial contribution year and $50,000 in subsequent years with a lifetime limit of $750,000 per household. This would result in a maximum investment tax credit of $8,000 (8% x $100,000) or $4,000 (4% x $100,000) in the initial year and $4,000 (8% x $50,000) or $2,000 (4% x $50,000) in subsequent years depending upon participation in a qualified retirement plan.

5.  Minimum Investment Amounts

As stated in the previous section, a sizable investment in a DIA is required in order to receive a meaningful amount of income. The amount of income in each situation is different depending upon each individual’s retirement income planning needs, the percentage of total income that’s targeted from sustainable income sources, and the amount that will be provided by other sources, e.g., Social Security.

Having said this, minimum investment amounts need to be established that will help meet one’s planning needs as well as make it profitable for life insurance companies to underwrite TCLAPs. I would suggest a required minimum investment of $50,000 in the initial contribution year and $10,000 in subsequent years in which an individual decides to add funds to his/her TCLAP. These amounts would be applied to all of a household’s TCLAPs if more than one is owned.

6.  No Income Restriction

Unlike many tax credits, including the retirement savings contributions credit that’s subject to a maximum income limitation, this wouldn’t be the case for TCLAPs. Everyone, regardless of income level, needs to save for retirement. To the extent that there’s a vehicle for doing so that provides sustainable lifetime income protection from stock market corrections, we shouldn’t be limited by income from making that investment.

7.  Maximum Income Start Age

Since a TCLAP would be a double tax-favored plan with its built-in exclusion ratio and legislated-investment tax credit, a maximum income start age would need to be included in order for taxation on the nonexcluded portion of income payments to begin at a reasonable time from an IRS perspective.

Given the fact that most nonqualified DIAs provide for a maximum income start age of 85 to 95, I would recommend a maximum income start age of 75 for a TCLAP. Although most people would opt for a starting age approximating the traditional retirement age of 65, this would encourage purchase of multiple contracts with different starting ages to meet changing income needs in retirement.

8.  Minimum Income Start Age

To encourage individuals to defer their income start date for a reasonably long time to increase their periodic income payments and to discourage investment for the sole purpose of obtaining the tax credit, a minimum income start age would need to be legislated. I would recommend that the later of age 60 or 10 years from the initial purchase date be used for this purpose.

9.  Flexible Income Start Date

Flexibility is important since TCLAPS would be used for retirement planning. This includes the income start date since it’s a known fact that people often retire earlier than planned for various reasons. Likewise, there are situations where individuals either elect or are forced to extend their working years.

Recognizing this, subject to IRS’ maximum and minimum income start ages (see #7 and #8), accelerated and deferred income start dates could be provided for as follows:

  • Earliest income start date: 1 year after the last premium payment
  • Latest income start date: 5 years after the original income start date

10.  Larger Return of Premium Than DIA Contracts

When you purchase a traditional DIA or QLAC, you can include a return of premium provision in your contract in exchange for a small reduction in your periodic income amount. This provides for an income tax-free death benefit payable to one or more beneficiaries equal to the amount of investment in the contract in the event that the annuitant(s) die before income payments begin.

Once again, to encourage individuals to take advantage of TCLAPs, I would recommend that the return of premium be increased from the traditional 100% of investment amount to 125% of all investments made at least five years before the death of the annuitant or surviving annuitant in the case of joint annuitants. The purpose of the five-year rule would be to remove the incentive of individuals in declining health who wouldn’t normally purchase a DIA from obtaining a guaranteed 25% return on investment in a short period of time for their beneficiaries.

11.  Ability to Use Funds for Long-Term Care Protection Prior to Income Start Date

In the event that one or both annuitants, as applicable, meets one of the two traditional long-term care insurance benefit triggers, funds could be withdrawn from a TCLAP tax-free to pay for long-term care expenses. The two benefit triggers are:

  • Inability to perform two out of six of the activities of daily living (ADLs): bathing, continence, dressing, eating, toileting, and transferring
  • Cognitive impairment

A TCLAP owner would be able to take advantage of this provision after being a TCLAP owner for a specified period, say ten years. At that time, upon submitting periodic proof of meeting one of the two benefit triggers from a physician, a TCLAP owner would be paid a tax-free cash benefit of up to $5,000 per month to be used for long-term care expenses with a lifetime limit of 125% of the cumulative TCLAP investment amount.

Long-term care payments would be in lieu of receiving lifetime income beginning at the contractual income start date. If the annuitant dies before receiving 125% of the cumulative investment amount, the remainder would be paid to the individual’s beneficiaries as a tax-free death benefit.

12.  Required In-Force Income Illustrations and Income Benefit Statements

Before you invest in a DIA, your life insurance agent will prepare an illustration showing the amount of periodic income that you will receive beginning on a specified date assuming that you make your investment today. When permitted, the illustration can also include planned future additional premiums.

Given the fact that a TCLAP carrier would be required to accept additional premiums (See #2) and it’s important to know the amount of additional periodic lifetime income that you will receive, insurance companies would be required to provide in-force income illustrations upon request.

Confirmation and annual statements would also be required to show original and revised periodic income payment amounts resulting from additional contributions beginning at the contractual income start date.

Timely Idea

The proposed “Tax Cuts and Jobs Act” introduced by House Republicans on November 2nd includes no incentives for saving for retirement. While it generally retains the current rules for 401(k) and other retirement plans, it would repeal the rules allowable Roth IRA conversions and recharacterization of Roth IRA contributions as traditional IRA contributions.

A Tax Credit Longevity Annuity Plan, or TCLAP, would be a timely addition, and potential cornerstone, to any tax legislation. It could, and should, be passed as stand-alone legislation in the event that Congress is unable to agree on a comprehensive tax plan.

A TCLAP would have widespread appeal given its potential to create private pension plans similar to what our parents and grandparents enjoyed while also providing for long-term care benefits should this need arise. Throw in concerns about the long-term sustainability of Social Security and you’ve got the perfect storm for a TCLAP.


By Robert Klein

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.