Except for the very wealthy or the blissfully carefree among us, one of the greatest fears as we grow older is outliving our money. Today the average 65-year-old male is expected to live until 86. In the same vein, there is a 50% probability that one of the spouses in a married couple will reach the age of 92. With these numbers in mind, the prospect of living 20 to 30 years without earned income can be daunting. The Obama administration tried to alleviate this situation by promoting a new type of retirement savings vehicle known as a qualified longevity annuity contract (QLAC). While not without limitations, this investment vehicle offers a real measure of protection against longevity risk.
Required Minimum Distributions
Before getting into a description of what a QLAC is, it is important to remember the concept of required minimum distributions (RMDs) that we discussed previously.
RMDs are the minimum annual distributions that the IRS expects you to take from your IRA, 401(k) and other qualified plans once in retirement. You can postpone taking those distributions until the year following the one when you reach 70.5. Failure to do so exposes you to severe penalties of 50% of the minimum amount that should have been withdrawn. RMDs are based on life expectancy tables.
What Is a QLAC?
QLACs are longevity contracts that benefit from a favorable tax treatment. Their purpose is to provide a guaranteed lifetime income. In exchange for a given lump sum, the owner receives an income flow starting at some pre-determined date in the future. However, unlike traditional annuities, they have no cash value and therefore can pay significantly higher guaranteed income to their owners. In addition, QLACs are qualified. This means that they are excluded from the calculation of RMDs. More specifically, one can use an IRA or 401(k) to buy a QLAC without triggering any immediate income tax liability. QLACs allow their owners to defer the payment of federal and state income taxes on the portion of their IRA used to buy the contract until the annuity stream starts, usually several years later. Only what is left on the IRA (post-QLAC lump sum) is used to calculate RMDs. The amount that can be invested in a QLAC is the lower of $125,000 or 25% of the value of your IRA. For a married couple, that amount can be doubled. (For related reading, see: Retirement Tips: Pick the Best Longevity Insurance.)
Important QLAC Details
- The QLAC can be written at any age before 85.
- The sooner it is written, the higher the annuity payment will be.
- Annuity payments must start, at the latest, at age 85.
Below is an example that illustrates the main attributes of a QLAC. The numbers that are used are derived from a recent and real situation.
Assume a 58-year-old man has a $500,000 IRA and wants to buy a QLAC that starts making monthly payments to him when he reaches the age of 80. He goes to one of the dozen insurance companies that provides those products and is told that a $125,000 lump sum in 2016 will allow him to receive the monthly equivalent of $35,000 of yearly income starting in 2038, when he turns 80. This annual payment of $35,000 is significantly higher than the annuity he could expect to receive from a traditional annuity product. This is because the QLAC has no cash value. The lump sum payment at the onset of the contract is used only to generate the income stream of later years and not as an accumulation (investment/savings) product. This in return allows the insurance company to pay a significantly higher annuity. (For related reading, see: Qualified Annuity Longevity Contracts: How QLACs Work.)
That $35,000 is guaranteed until death and can be adjusted for inflation, at a cost. Income taxes on the $125,000 of IRA money used to buy the QLAC are postponed until year 2038 when they are taken from the $35,000 annual income stream. If the QLAC owner dies before he starts receiving the annuity stream, his beneficiary receives the $125,000, unadjusted for earnings. If he dies at age 82, two years after the first payment has been made, the contract can be written so that his heirs will receive the equivalent of $125,000 minus the value of the annuity payments already made. The contract can be written as a single annuity or as a joint annuity. If a joint annuity is chosen, the annual stream will be reduced when compared to a single annuity but the contract will remain in force for the benefit of the surviving beneficiary. In this case the $35,000 annual payment would be made until the second spouse dies.
QLAC and Term Life Insurance
To use an analogy, the QLAC is to annuities what term life insurance is to whole life insurance. It allows you to buy pure protection against longevity risk the way term life insurance allows you to buy pure benefit insurance. It cannot be used as a savings/investment account (like traditional annuities and whole life insurance) and therefore pays a much higher annual benefit, once you reach the trigger year (2038 in our example).
The two significant advantages of this product are guaranteed lifetime income starting at a certain age and deferral of income taxes until the first annuity payment is received. The main drawback of the product is that the retiree who has a QLAC must live on a reduced potential income until the annuity stream starts.
A good friend of mine recently told me that he bought a QLAC. Since he happens to be a highly regarded and well-known researcher in the asset management world and one who is particularly knowledgeable about retirement issues, I thought a note on this subject was warranted. I hope you have found it helpful.