Retirement can be an exciting time for many individuals, but it can also be a time of uncertainty and financial insecurity. One way to alleviate this uncertainty is by investing in a Qualified Longevity Annuity Contract, or QLAC. However, as with any investment, there are pros and cons to consider before making a decision
A qualified longevity annuity contract (QLAC) is a type of deferred annuity. It’s funded by a qualified retirement account — such as a 401(k), a 403(b) or an IRA — to be converted into an annuity. A QLAC is protected against stock market downturns and provides guaranteed monthly income for life.
In 2014, the U.S. Treasury Department issued rules permitting any individual with a qualified retirement plan, such as a 401(k), a 403(b) or an IRA, to use his or her retirement savings to purchase a qualified longevity annuity contract (QLAC), which is a type of deferred fixed annuity. Buying one can be a smart way to optimize your retirement plan — particularly if you’re a conservative investor.
QLACs are designed for people with minimal appetite for stock market volatility and the desire for hands-off, guaranteed income. They offer additional value to individuals that wish to sidestep the IRS required minimum distribution (RMD) rules that govern qualified retirement plans.
QLAC Lifetime Purchase Limit
Qualified retirement plan owners can purchase up to $200,000 in QLACs. An earlier provision that limited it to a percentage of their total retirement account savings was done away with in the SECURE Act 2.0. For IRAs, the limit pertains to the sum of all account balances. Aggregate QLAC purchases, regardless of source, cannot exceed $200,000.
Who Should Buy a QLAC?
QLACs are best suited for people nearing retirement with concerns about outliving their nest eggs or have a desire to diversify their assets. While relatively low-yielding, QLACs address both concerns – providing a guaranteed, lifetime stream of income that exhibits zero volatility.
The predictable nature of QLACs is highly attractive, but it’s a secondary benefit for some investors. Individuals utilize QLACs to optimize their tax positions, taking advantage of IRS allowances to defer the required minimum distributions (RMDs) associated with traditional retirement plans.
The type of person that could benefit from incorporating a QLAC into a retirement plan generally exhibits the following characteristics:
- Good health with a family history of longevity (life expectancy well into late 80s or 90s)
- Owner of a qualified retirement plan, such as 401(k), 403(b) or IRA, with enough money to cover near-term retirement spending needs and a desire to minimize taxes
- Independent mindset, with a desire to avoid becoming a burden to his or her children during retirement
Consider Harold, a 71-year-old guy with a sizeable 401(k). He’s been wrestling with the idea of retiring, and his financial advisor has briefed him about RMDs, which are to begin next year.
While some aspects of retirement appeal to Harold, he gets a lot of satisfaction from his work, and he enjoys the structure of his day. After careful consideration, he opts to continue working until age 77 — either with his current employer or in a freelance capacity.
After discussing things with his advisor, Harold decides to transfer $100,000 of his 401(k) savings to a QLAC. Doing so will allow him to reduce next year’s RMD and avoid moving into a higher tax bracket. On top of that, it will reduce Harold’s concerns about outliving his savings.
In order to minimize his taxes, Harold plans to leave the QLAC money invested until age 85. He’s confident he’ll have enough income to live comfortably. At 85, the annuity income will bolster his cash flows.
A QLAC is typically not a smart choice for a person that has no worries about running out of money since they do not have a longevity risk to insure. Purchasing one may offer some tax advantages, but they are unlikely to make a material difference.
Qualified Longevity Annuity Contracts and Tax Advantages
According to the U.S. Treasury Department, qualified longevity annuity contracts can provide a cost-effective solution for retirees who are willing to use part of their savings to protect against outliving the rest of their assets. QLACs can also help you defer your tax obligations for longer than possible with qualified retirement plans.
How the Contract Works
A QLAC provides a guaranteed stream of monthly income that begins at a future date of your choosing. If desired, the payments can be deferred until you reach 85 years old.
Some annuity providers allow you to change the start date of your payments, but no changes can be made to the contract once payments begin.
The size of the payments depends on the amount of money you put into the contract, plus the amount of interest earned. Generally, the longer you wait to begin receiving payments, the higher the payments will be.
Reducing Required Minimum Distributions
If you keep money in a traditional retirement plan, you must take a required minimum distribution (RMD) each year, beginning at the age 73 — or 72 if you reach 72 before January 1, 2023. Failure to do so will result in a penalty of 25% or 50% of the RMD depending on your age.
Generally, RMDs cannot be aggregated across accounts. A distinct RMD must be taken for each unique account, but exceptions exist for 403(b) plans and IRAs.
Unlike 401(k) plans, 403(b) plans and traditional IRAs, Roth IRAs do not have required minimum distributions imposed on them.
The various rules are somewhat complex. If you have a financial advisor, be sure to leverage his or her expertise to get your hands around everything.
RMD Exemption for QLACs
QLACs are exempt from RMD rules. With a QLAC, you can defer receiving income payments until age 85. By deferring payments, you may be able to avoid getting bumped into a higher tax bracket, and in turn, you could lower your Medicare premiums. This strategy can be especially effective if you end up working beyond age 73.
The IRS offers a RMD worksheet with formulas to help determine RMDs at specific ages. According to the worksheet, you take your retirement account balance as of Dec. 31 of the previous year and divide it by the distribution period associated with your age on your birthday in the current year.
The 2023 age-based distribution periods, which reflect the IRS’ Uniform Lifetime Table, are illustrated below. They pertain to all retirement accountholders, except those whose sole beneficiary is a spouse that is more than 10 years younger. For them, values from the IRS’ Joint Life Expectancy Table must be used. Additionally, when dealing with an inherited IRA, distinct rules apply.
Required Minimum Distribution Worksheet
Strategies and Considerations Before Purchasing a QLAC
When you purchase a QLAC, you’re exchanging the potential for wealth accumulation for a guaranteed stream of income in retirement. It’s a hands-off approach to investing that will not expose you to any volatility.
However, the opportunity cost of locking up your money in a QLAC can be considerable. Fortunately, there are several strategies that can help mitigate this risk.
Add a Death Benefit
A return-of-premium death benefit is a valuable feature, or rider, that can be added to a QLAC. Upon death of the annuitant — or annuitants, in the case of a joint-and-survivor annuity — it allows a contract owner to transfer any remaining assets in an annuity to a named beneficiary. Without the death benefit, all remaining assets are surrendered to the issuing insurance company.
Incorporate a Cost-of-living Adjustment (COLA)
A cost-of-living adjustment (COLA) is another valuable rider you can add to a QLAC at the time of purchase. A COLA indexes the annuity’s payments to inflation readings, such as those computed via the Consumer Price Index (CPI).
Unfortunately, a COLA add-on invariably means reduced payments, at least initially. You need to carefully evaluate whether the inflation protection justifies the lower initial payments, given your life expectancy.
Ladder Your QLACs
Annuity laddering is a financial strategy that involves buying a handful of relatively small QLACs over several years instead of putting all the money into a single QLAC. The strategy is an effective way to mitigate interest-rate risk.
Staggering QLAC purchases makes sense if you think interest rates will go up. Spreading the purchases over time prevents you from getting locked into a single fixed rate and missing out on higher income in later years.
It’s a wise way to increase your QLAC payout potential while maintaining some financial flexibility. However, in a falling rate environment, this strategy will result in diminished earnings.
Check Out the Issuer’s Financial Strength
QLACs are insurance products backed by insurance companies. However, a QLAC is not insured in a literal sense. It is backed by the financial strength of the issuing company.
In the event of a default, state guaranty associations offer some protection, but it may not be enough to make you whole. Therefore, you should strive to buy QLACs from insurance companies that are in superb financial condition.
The best annuity issuers have well-established track records with strong balance sheets and resilient operations. Their financial strength is signified by an A.M. Best Company Financial Strength Rating of at least “A-: Excellent.”
QLAC Pros and Cons
As with any financial instrument, the benefits and risks of a QLAC should be carefully considered prior to purchase. Some of the more prominent considerations are outlined below.
While QLACs can be a sound investment choice for an individual that is concerned about longevity risk, it makes little sense for an individual that is unlikely to outlive his or her savings.
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