Authors: Alex Coriddi and Alicia Wall
Many retirees worry about running out of money before they run out of life, and the insurance industry has come out with a product to alleviate this concern: the Qualified Longevity Annuity Contract (QLAC). QLACs just recently became available in July 2014, and a lot of new retirees are hearing about them—but these contracts may sound more promising than they really are. If you’re curious about purchasing a QLAC, below is some important information and a real-life example to consider.
What’s a Qualified Longevity Annuity Contract (QLAC)?
A QLAC is a deferred income annuity, used to mitigate the risk of outliving your assets in retirement. It works like this: you take up to $125,000 from your qualified retirement plans—those in your IRA, 401(k), 403(b), and/or governmental 457(b) accounts—to fund the QLAC. These assets remain tax deferred until you elect to begin receiving income from the contract, at which date the insurance issuer pays you a fixed amount each month for the rest of your life.
The Benefits of a QLAC
The benefits of a QLAC are twofold:
- A QLAC provides you with lifetime insurance on a portion of your retirement assets. Investment risk is shifted onto the insurer—even if the market plummets, you still get the same guaranteed monthly payment throughout your lifetime.
- QLACs can help customize your RMD plan and provide additional tax benefits. Tax-deferred income saved in retirement plans is subject to Required Minimum Distributions (RMDs), which are minimum amounts that the IRS requires you to withdraw from your qualified retirement accounts each year beginning at age 70½. QLACs are excluded from RMD calculations, so you won’t pay taxes on these assets until you begin receiving monthly income payments.
- QLACs have strict premium limits.
- The maximum amount you can fund a QLAC with is the lesser of $125,000 or 25% of the retirement account’s value at the time you purchase the contract.
- The funding source has to be a qualified retirement account.
- You must begin income payments before your 85th
- Monthly payments will start automatically on whatever date you stipulate in the contract, but this can’t be past age 85.
- Withdrawals aren’t allowed.
- QLACs are irrevocable and illiquid investments. You can’t withdraw your lump sum premium payment, but will simply receive your monthly payments beginning on the future start date you specify.
Leaving QLAC Assets to a Beneficiary
Traditional, Single Life QLACs pay out for your lifetime, and then stop when you pass away. However, some issuers allow you to elect the following specific features to pass these assets to a beneficiary:
- A Joint Life QLAC offers a spousal benefit plan where monthly payments will continue throughout your surviving spouse’s lifetime.
- A Cash Refund Death Benefit, also referred to as a “return of premium” option, pays a lump sum death benefit to specified beneficiaries if you pass away before the total annuity payments you’ve received from the contract exceed the amount that you originally invested.
- What fees are involved in purchasing a QLAC? QLACs are fixed annuities and have no separate annual fees. Instead, commissions to the agent are built into the calculation of your monthly payment amount, reducing your annuity payments. This cost is relatively low when compared with fully-loaded variable or indexed annuities.
- How would my monthly annuity payments be calculated? Your monthly payment amount is calculated by the individual insurance company issuing the contract and is based on IRS actuarial tables. Payments are determined by your premium amount and the age you elect to start receiving payments. Generally, the longer you defer payments, the more the contract pays you each month. Benefit elections, such as the spousal benefit and the return of premium death benefit, will reduce monthly payments.
- Can I fund multiple QLACs with $125,000 each from different qualified retirement plans? Regardless of how many qualified retirement plans you have, the cumulative dollar amount invested into all QLACs from all retirement accounts can’t exceed the lesser of $125,000 or the 25% account value threshold. The $125,000 limit will be assessed each year by the IRS and adjusted for inflation accordingly. These limitations do apply separately for each spouse with their own retirement accounts.
Joe Smith is 68, in a 40% tax bracket, and is invested 80% in equities and 20% in fixed income. He has $500,000 in his Traditional IRA and is deciding between two options:
- Purchase a QLAC with $125,000 of IRA assets and receive a $1,861/month after-tax distribution for the rest of his life, beginning at age 85.
- Do nothing. Leave the $125,000 invested in his IRA.
Assuming Joe lives until age 95:
The average annual return that $125,000 in his IRA would have to earn (option #2) in order to break-even with the cumulative dollar amount received from QLAC annuity payments of $22,327 per year from age 85 to 95 (option #1) is 3.1%, after tax. In other words, option #2 is the favorable choice if Joe’s IRA earns more than 3.1% per year. With an 80%/20% portfolio it’s reasonable to expect average annual earnings well above this rate over the long term.
Assuming Joe lives until age 90:
If we decrease Joe’s life expectancy to age 90, his IRA only needs to earn more than 0.4% after tax to favor option #2. The shorter your life expectancy and the more your IRA is expected to earn, the less favorable purchasing a QLAC becomes.
Let’s look at what this means in terms of dollars: if we assume a long-term average investment return of 7% per year, option #1 where Joe purchases the QLAC would yield him $956,000 in total retirement assets by age 90 versus $1.22 million if he elects option #2 and leaves all retirement assets in his IRA. This tells us that from a purely quantitative standpoint, Joe will earn more dollars over his lifetime from having his $125,000 invested in his IRA rather than a QLAC, even with the QLAC’s tax deferral benefits.
As we see in the above example, it’s unlikely that QLACs will prove appealing for retirees in today’s low interest rate environment. These types of contracts may become more favorable in the future as interest rates rise and insurance companies become more competitive.
A QLAC can seem like an attractive retirement income strategy if you’re worried about outliving your assets. But, while QLACs may be appropriate for some retirees, often when we run the numbers it’s preferable to simply leave these assets to grow in their original retirement accounts. If outliving your money is a principal concern, it’s also important to keep in mind that having an appropriate Social Security collection strategy is still one of the most effective longevity hedges out there.
To best understand what retirement planning strategies are appropriate for your particular situation, consult your Wealth Advisor.
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The name of the client discussed in real life example has been changed to protect their privacy.
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