Take-Away: The purchase of a qualified longevity annuity contract using an IRA’s assets is not a wise move just  to delay taking, or reducing,  required minimum distributions.

Background: Several years ago Congress amended the Tax Code to permit the use of a portion of an IRA or 401(k) account to purchase a qualified longevity annuity contract. [IRC 401(a)(9).] Recently, some commentators have  advocated that more retirees should take advantage of a qualified longevity annuity contract [QLAC] given longer life expectancies and the threat of increased income tax rates.

Advocates Reasons for a QLAC: Some commentators stress that a qualifed longevity annuity contract [QLAC] permits the owner of a traditional IRA or a 401(k) to use a portion of their retirement account to purchase a deferred annuity. That amount used to purchase the annuity will not be currently considered in the determination of a retiree’s annual required minimum distribution [RMD], effectly reducing that taxable RMD. As life expectancies increase and the discussion in Congress about raising income taxes gains momentum, these commentators [most often folks who sell life insurance and annuities] advocate that retirees take a look at adding a QLAC to their IRA or qualified plan account.

QLAC Basic Rules: The Tax Code now allows for the transfer of traditional IRA or 401(k) funds used to purchase an annuity, which is a notable exception considering that IRAs are not permitted to hold any life insurance contracts. Retiree’s have little control over the management of their RMDs. Other than a qualified charitable distribution (QCD), about the only other way to manage, to a limited degree, a retiree’s annual taxable RMD is with a qualified longevity annuity contract (QLAC.) Some of the key rules for a QLAC include:

Age 85 Deferral: The QLAC can delay distributions of amounts placed in the annuity until a later date, but not later than the retiree’s 85th birthday. Accordingly, the funds used to purchase the annuity are not taken into consideration to determine that retiree’s RMD for each year, until the retiree’s 85th birthdate, at which time the annuity contract will be annuitized and ordinary income will be paid to the annuitant from the annuity contract- along with the annuitant’s RMD from the remainder of his or her IRA (or 401(k) account.) In short, the QLAC is not an income tax avoidance device; rather it is just an income tax deferral strategy.

Commercial Annuity: The annuity contract is purchased from an insurance company; either the purchase is with a lump sum amount or a series of premium payments. The QLAC can neither have a commutation benefit nor a cash surrender value. [Regulation 1.401(a)(9)-6.]

Annuitant: Existing rules allow a spouse or someone else to be a joint annuitant with the retiree, so both lives are covered regardless of how long they live.

Maximum Amount: The maximum amount that can be used to purchase the annuity with IRA or 401(k) account assets is either (i) 25% of the retirement account balance, or (ii) $135,000, whichever amount is less.

Limit on Types of Annuities: No variable annuities or indexed contracts can be used as an QLAC. However, an annuity that is purchased as a QLAC can incorporate cost-of-living adjustments to the amount of annuity that is paid to the retiree.

Return of Premium Annuity ‘Rider:’ The Regulations will permit the QLAC to have a ‘return-of-premium’ death benefit payable to heirs as an annuity policy option. However, if that policy ‘rider’ is selected, the amount of the annuity installment will be less than if the ‘rider’ had not been selected.

Benefits of a QLAC: A quick summary of the benefits of a QLAC include:

  • The annuity acts as a hedge against the annuitant’s unexpected longevity, thus providing the retiree peace of mind that he/she will not outlive their retirement income;
  • The annuity guarantees monthly payments until the retiree’s death, acting as a hedge against inflation;
  • The purchase of the annuity will delay, or more accurately reduce, RMDs for the retiree for 13 years, which may translate to lower income taxes;
  • The annuity may provide a better internal rate of return (IRR) than an immediate annuity, but still the rate of return is no greater than 6% until the annuitant is age 100; and
  • The annuity could be viewed as an inflation hedge or an income stream that can be used for long-term care planning.

Why a QLAC Might Not be a Good Investment: Some of the reasons why the purchase of a QLAC might not be a wise move include:

  • The retiree loses control over the money or funds used to purchase the annuity;
  • There is a risk that the issuing annuity insurance company may become financially weaked over the years and unable to meet its annuity payment obligations when they arise;
  • The QLAC is irrevocable;
  • The QLAC cannot have a cash surrender value and cannot be commuted, i.e. converted to cash;
  • The retiree must live into his or her late 80’s before the purchase price used to acquire the QLAC is at a ‘break-even’ point;
  • Once the QLAC is actually annuitized, i.e. once the retiree is age 85 and starts to receive taxable annuity distributions, those taxable annuity distributions will be paid out at a faster ‘pace’ than if the funds had been paid out as part of an RMD;
  • There is the lost opportunity cost by converting the possible growth in IRA investments into a future fixed annuity stream;
  • The retiree-annuitant could die ‘early’ and never recoup the up-front cost of purchasing the annuity; and
  • Repeating the obvious, a QLAC only defers income taxation with regard to the retiree’s RMD, it does not avoid those income taxes.

Conclusion: It will be a rare individual who would find a QLAC a suitable investment for their IRA or 401(k) account. Reducing a retiree’s annual RMD always sounds appealing, but the limits imposed on how much can actually be invested in a QLAC, and the reality that the tax deferral is only 13 years, makes the attractiveness of a QLAC fairly illusory.