It is no secret—people are living longer these days. The longer time horizon means more time spent in retirement and more concerns about funding all those extra years. No one wants to run out of money deep in retirement, so it is understandable many fear outliving their resources and not having adequate income for long-term care and other retirement expenses. For retirees with Individual Retirement Accounts (IRAs) and 401(k) savings funded with pretax money, the annuity industry has a product for you: Qualified Longevity Annuity Contracts (QLACs). They are a type of longevity annuity that allows payments to be deferred until sometime in the future. A QLAC lets you swap some money in your qualified retirement plan to guarantee monthly payments for the rest of your life after a specified date.
Although QLACs are designed to appear useful, they have several limitations you should weigh carefully.
QLACs are a type of deferred income annuity that can help reduce required minimum distributions (RMDs), which are the minimum amount you must withdraw from qualified accounts every year. RMDs force you to start withdrawing funds from your IRA and 401(k) accounts after you reach age 70½—so the IRS can tax it. In July 2014, the Treasury Department changed the rules so the value of QLACs is shielded from RMD consideration until age 85. So, if you convert a portion of your IRA or 401(k) savings into QLACs, that money isn’t subject to mandatory withdrawals when you hit 70½. This could lower your tax bill until you reach 85. Thereafter, annuity payments are factored into the calculation of your RMD and are taxed as ordinary income.
Another potential benefit of QLACs is they aren’t considered assets under Medicaid guidelines. Although the Affordable Care Act eliminated federal asset limits, some states impose their own asset tests, and they are still required for long-term care. So if you are (or would like to be) covered by Medicaid and eligible for long-term care, QLACs may help protect your assets from spend-down requirements.
Qualifying funding sources include IRA and 401(k) plans, as well as 403(b) and 457 retirement accounts for public school and government employees. But there are restrictions on how much you can put into a QLAC. In aggregate, only 25% of all your qualifying accounts up to a maximum of $130,000 is allowed, as of January 2018.
Once purchased, funds are irrevocably committed and annuity payments start at a predetermined date (up to age 85, by which time they must begin). You may be able to change the annuitization date depending on the contract, but that triggers a recalculation of the guaranteed payout. If you delay the RMDs until age 85, you will have a larger guaranteed payout, which means a potentially larger tax impact than if you had taken the RMD at 70½.
Although QLACs provide a lifetime income stream and help lower your tax bill for a time by allowing you to reduce and defer RMDs, are they worth it? In our view, the answer is frequently no. QLACs suffer many of the same drawbacks as any other annuity:
In short, a QLAC likely lowers lifetime returns and adds an extra layer of complication and paperwork compared to what a disciplined retirement plan can provide you without it.
If you own longevity annuities, have a portfolio of $500,000 or more and would like more in-depth evaluation, contact us.
[i] Source: Factset, as of 2/12/2018; from 12/31/1925 to 12/31/2017, average annualized inflation was 2.91%, based on the US BLS Consumer Price Index.