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Securing Income and Reducing RMDs

Last update on: Oct 12 2016

You should be familiar with QLACs. They are a growing force in retirement in-come planning. In 2014 the IRS approved them as a way to secure a stream of lifetime income and to reduce required mini-mum distributions (RMDs) and the income taxes they generate. Even if you never buy one, you should understand them and know why you aren’t buying one.

A qualified longevity annuity contract (QLAC) is a special type of longevity annuity. A longevity annuity, also called a deferred income annuity (DIA), is a relatively new type of annuity, first issued in 2004. You buy a guaranteed lifetime stream of income by paying a lump sum to an insurer. The income payments are delayed for as little as two years or as many as 45 years after you buy the annuity. When you buy the annuity, you decide when the income payments will begin. Income payments from QLACs can start as early as 72 or as late as 85. You also can buy a ladder of QLACs, so income payments begin in different years, providing higher income over time. The later the income payments begin, the higher they will be.

The longevity annuity ensures you won’t run out of income during your lifetime. You’ll always have income from Social Security (the best inflation-adjusted longevity annuity you have) and the longevity annuity.

Many like to buy DIAs in their 50s and plan income payments to begin between 65 to 70. This is a cheaper way to prepay retirement income than waiting until retirement and then buying an immediate annuity, according to Wade Pfau, a professor at The American College. He calculates that you receive more income per invested dollar from a DIA.

A QLAC has an added benefit for your IRA.

Longevity annuities and other types of annuities have been purchased in IRAs for years. Until 2014, it wasn’t clear how a longevity annuity affected the calculations of RMDs, and most insurers required income payments to begin by age 70. The IRS resolved that in 2014 with new regulations that enhance QLACs in IRAs.

When you own a QLAC in your IRA, the balance in the QLAC isn’t used to calculate your RMDs until income begins or age 85, within limits and whichever is first.

RMDs are a major problem for many traditional IRA owners. The tax code forces them to take distributions each year after age 70½ whether or not the income is needed. The distributions are calculated using life expectancy tables and are intended to drain the IRA over a person’s lifetime. A higher percentage of the IRA is distributed as the owner ages, and in the late 70s and beyond the RMDs often greatly exceed what the owner needs. The RMDs from a traditional IRA are included in gross income, so this creates an income tax problem. 

Under the 2014 regulations, the amount invested in QLACs isn’t used to calculate RMDs, up to a total of $125,000 invested or 25% of your IRA balance, whichever is less. The limit is calculated by aggregating all your IRAs. In other words, it is a per taxpayer limit, not a per IRA limit. The limit is determined by comparing the amount invested in QLACs to the IRA balance as of the end of the previous calendar year. Married couples apply the limits per person. Each spouse can invest up to $125,000 or 25% of his or her IRA in QLACs.

QLACs also can be purchased through participating 401(k) and similar plans and limit RMDs from them. The 25% limit applies to each plan, and the $125,000 limit is per person. Right now it is difficult to find a 401(k) plan that offers a QLAC as an investment option.

The $125,000 limit is indexed for inflation, but it will rise only in $10,000 increments. At recent inflation rates, it will take it a while to increase.

Many people would benefit from excluding up to 25% of their IRA balances from the RMD calculations, and they can do that by having their IRAs buy QLACs. The QLACs delay the RMDs for that part of the IRAs until age 85 or when the income begins, whichever is first.

A longevity annuity doesn’t have to be a use-it-or-lose-it asset. Most people believe you and loved ones don’t receive anything if you don’t live to the age when income distributions begin. But there is more flexibility. You can have a joint QLAC with your spouse that pays until both pass away. You also can structure the QLAC to provide some income or return of premiums to a beneficiary if you pass away prematurely. 

Remember the annual payment is locked in when you buy the annuity. The scheduled income payment might seem sufficient when you purchased the annuity but the purchasing power will be less over time. Inflation protection can be added, but it is expensive; it reduces the initial income. Request quotes of the income with and without inflation protection.

Keep in mind that adding any of these benefits reduces the income you’ll receive.

Once a QLAC is purchased, limited changes are allowed. Most insurers allow one change to the payout date. You also might be able to add money to the annuity, but a new income payout amount will be calculated for that contribution.

You should know that not all longevity annuities are QLACs. Any issued before the July 2, 2014, date of the IRS regulations don’t become QLACs. Your IRA can own a longevity annuity that isn’t a QLAC, but it won’t help reduce the RMDs. Instead, you have to buy an annuity issued after the regulations. The insurer has to identify it as a QLAC meeting the IRS regulations and not as a standard longevity annuity. Variable annuities, indexed annuities, and other types of annuities also aren’t going to meet the QLAC requirements.

You can’t own a QLAC in a Roth IRA. You might want to own a regular longevity annuity in a Roth IRA to provide guaranteed income later in life.

QLACs and longevity annuities are among the simplest of annuities. You can use them to increase guaranteed income late in life. Or you can buy them before retirement with the intention that they’ll be part of your guaranteed income from the start of retirement.

Only a few insurers issued longevity annuities for years. But the IRS regulations quickly brought change. Major insurers began introducing their versions. Now, about 10 insurers issue QLACs and 15 offer DIAs.

To learn more about longevity annuities and QLACs, including details about the different types available, contact Stan Haithcock, also known as Stan the Annuity Man. You can receive a free printed copy of his QLAC Owner’s Manual by calling 800-509-6473 or online at www.stantheannuityman.com. Roll over “Resources” and then roll over AnnuityMan Owner’s Manuals.

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