What Is a Qualified Longevity Annuity Contract (QLAC)?
A QLAC annuity provides guaranteed monthly payments until death and is shielded from downturns in the stock market. As long as the annuity complies with Internal Revenue Service (IRS) requirements, it is exempt from the required minimum distribution (RMD) rules until payouts begin after the specified annuity starting date.
- A QLAC is a retirement strategy in which a portion of required minimum distributions (RMDs) are deferred until a certain age (maximum limit is 85). The insurer takes on market and interest rate risk.
- Under current rules, an individual can spend 25% or $135,000 (whichever is less) of their retirement savings account or IRA to buy a QLAC.
- The main benefit of a QLAC is a deferral of taxes that accompanies RMDs.
What Is An Annuity?
Understanding a Qualified Longevity Annuity Contract (QLAC)
One of the biggest fears many people have as they grow older is outliving their money. A QLAC is an investment vehicle that allows funds in a qualified retirement plan, such as a 401(k), a 403(b), or an IRA, to be converted into an annuity.
An annuity is a contract purchased from an insurance company in which the buyer pays the insurance company either a lump sum or a series of premiums. At some point in the future, the insurance company pays back the annuity owner—called the annuitant. How many years the owner receives payments depends on the type of annuity purchased.
A qualified longevity annuity contract provides a lifetime of income once the preset annuity start date is reached. The longer an individual lives, the longer a QLAC pays out. One of the benefits of using IRA funds to purchase a QLAC is that it helps to avoid violating the IRS RMD rules for those turning age 72. A required minimum distribution (RMD) is the minimum amount that must be withdrawn—per the IRS—from a person's retirement account balances each year starting when they turn 72 years old.
A QLAC allows for a transfer of IRA funds to be used to purchase the annuity. Since a QLAC is a deferred annuity, the product allows distributions to be delayed until a future date but no later than the person's 85th birthday. In other words, the amount that has been transferred to buy the QLAC doesn't have any required minimum distributions until the predetermined payout date for the annuity.
Another benefit of a QLAC is that it allows a spouse or someone else to be a joint annuitant, meaning that both named individuals are covered regardless of how long they live (with some conditions).
In effect, QLACs act as longevity insurance. As such, they are a valuable tool in retirement income planning. The IRS sets an annual maximum amount that can be used to purchase a QLAC using IRA funds. In 2020 and 2021, an individual can spend 25% or $135,000 (whichever is less) of their retirement savings account to buy a QLAC via a single premium.
The maximum age to which QLAC funds may be deferred
Qualified Longevity Annuity Contracts and Taxes
QLACs have the added benefit of reducing a person’s RMDs, which IRAs and qualified retirement plans are still subject to, even if they do not need the money. This can help keep a retiree in a lower tax bracket, which has the added benefit of helping them avoid a higher Medicare premium.
Once a retiree’s QLAC income begins flowing, it could increase their tax liability. However, if managed correctly, any additional tax liability can be minimized if other taxable retirement savings income sources are spent down first.
The promised benefit of QLACs can only be achieved if rules set by the IRS are followed. The annual distribution is based on the value of the account at the end of the preceding year.
Qualified Longevity Annuity Contract Considerations
One option for getting the most out of QLACs is by laddering them, which would involve purchasing one QLAC each year for several years (in the $25,000 range, for example). Such a strategy is similar to dollar-cost averaging, which makes sense considering that annuity costs can fluctuate along with interest rates. In other words, a QLAC could be purchased each year, which has the potential of lowering the average cost of the contracts.
All of the laddered annuity contracts could be structured to begin paying out in the same year. Each contract could also have its payouts staggered to begin paying out in different years based on the owner's age and when the income is needed. For example, the first QLAC purchased could begin paying out at age 78, and the next could begin at age 79, and so on. However, RMDs would need to be taken by age 85.
QLAC buyers are often given the option of adding a cost-of-living adjustment to their contract, which indexes the annuity against inflation. Deciding on this depends on life expectancy, as the cost-of-living adjustment will reduce the QLAC’s initial payout.
The biggest risk of buying a QLAC is the financial strength of the issuing company. If it goes bankrupt, the QLAC may not be enforceable. QLAC buyers should consider buying more than one from different issuers to limit their risk.
The biggest risk in buying a QLAC is the financial strength of the issuing company, as they may not be enforceable if the company goes bankrupt.
Example of a QLAC
Take Shahana, who is 67 and due to retire in three years. She would like to save on tax liabilities from her RMDs. Based on her current retirement account balances, Shahana's first year RMD is likely to be approximately $84,000 once she turns 72 years old.
But Shahana has other plans. She has made investments in other assets, such as stocks, bonds, and real estate, which should provide her with an income stream during retirement. Besides this, she plans to consult on a part-time basis to stay current in her field and earn extra cash. All in all, she expects to lead a retirement lifestyle that is comfortable rather than lavish.
To make adequate preparations for her old age, she invests $100,000 in a single premium QLAC account from her IRA savings that she plans to withdraw when she turns 85. This will delay her RMD withdrawal date by 13 years (from age 72) for the $100,000 that was used to purchase the QLAC.
When Shahana turns 85 years old, she'll have guaranteed income from the QLAC for the rest of her life. This income stream could be a potential lifesaver if her other IRA accounts are depleted by that time.
Also, the money set aside in the QLAC is excluded from her IRA assets when determining her annual RMDs (until she turns 85 years old). The effect would lower Shahana's RMDs from age 72 to age 84, resulting in lower income taxes in those years. However, she will eventually need to pay income taxes on the distribution amounts from the QLAC, but she'll likely be in a lower tax bracket at age 85 versus her earlier years.