If you are age 70-1/2 or older, you may have experienced sticker shock when you found out how much money you're legally required to withdraw from your IRA or 401(k) account in what is referred to as a "required minimum distribution." The RMD is the amount that Uncle Sam compels you to withdraw from your qualified retirement savings plans when you reach age 70-1/2 and in each year thereafter for the rest of your life.
There are a number of ways to lessen this blow, and a qualified longevity annuity contract, or QLAC, might be one of your options. These special annuities, which only came on the scene in 2014, let you keep more of your retirement savings untouched and enjoying tax-free growth when you start taking RMDs. That means a potentially bigger and longer-lasting nest egg.
Let's quickly go over the basics QLACs. A QLAC is a type of longevity annuity, an insurance product that you buy up front in exchange for a guaranteed stream of income that will begin at some point in the future and last for the rest of your life. These payouts are not affected by market conditions and are guaranteed by the insurance company. Another benefit is that they can help you project what your income will be in your retirement years.
This is the underlying framework of a QLAC. However, QLACs come with additional benefits that set them apart from other longevity annuities. Namely, a QLAC allows the insured to withdraw 25% -- up to a maximum of $125,000 for single folks and $250,000 for married couples -- from their qualified retirement accounts and exempt these funds from being considered in their RMD calculation from age 70-1/2 onward.
Why it came about
One of the main purposes of the QLAC is to help overcome the "longevity problem" -- that is, the fact that many Americans will outlast their retirement savings because they're living longer than ever before. According to the Society of Actuaries, as of 2012, 16.6% of male retirees will live past 95 years old, and 4.2% will live to be 100. This means that many of us may spend a quarter-century or more in retirement, and the longer we live, the greater the risk that we'll run out of money.
Annuities work by pooling funds, which means that if you happen to be one of the lucky few who live to 95 or 100, your income from the annuity will be greater than it would be if you had saved the funds on your own, as you'll receive payments for much longer than those who did not live as long. This is similar to the mechanism that makes pensions work.
A collateral benefit of the QLAC is that it is not subject to RMDs beginning at age 70-1/2. To put this benefit in dollars and cents, let's say you're 71 and your spouse is within 10 years of your age. According to the IRS Required Minimum Distribution Table, your RMD factor would be 26.5 (meaning your RMD would be the total amount of your qualified retirement savings divided by 26.5). If you had moved $125,000 over to a QLAC, then you would be required to take approximately $4,717 less out of your qualified accounts for the year than you would be had you not purchased a QLAC ($125,000/26.5 = $4,717).
The exact tax benefit of this would depend on your marginal tax bracket, which could be as high as 39.6%. This would also reduce the dollar amount of all of your future RMDs. These lower RMDs may also have an effect on other income-related assessments like Medicare Part B premiums.
The QLAC, which can be purchased at any age, allows deferral of income up to age 85, at which time the insured must begin to take income (annuitize). The limit on total contributions is the lesser of $125,000 per person or 25% of the insured's qualified portfolio. If the insured dies before the payout begins, then payments may be directed to a spouse or named beneficiary. In some cases, a premium refund may be allowed if that option was selected when the QLAC was initially purchased.
You must keep in mind that purchasing a QLAC is an irrevocable decision. Once you fund the annuity, you cannot change your mind. The rules are strict!
Further, this is a fixed annuity, so the growth potential is small. Many experts strongly recommend purchasing an inflation rider (or COLA), which will make your payouts rise in line with inflation.
A QLAC won't save you a ton in taxes on its own, but it offers you one more weapon in your arsenal of tax saving and planning strategies.
Be sure to investigate the various riders, such as optional death benefits, income riders, and inflation options. All of these may lower your annuity benefit initially (because they cost a bit), but they may pay back big-time if you are one of those long-lived folks. Remember, this is insurance; it's not meant to make you rich, but rather to provide you with a secure source of future income.