In 2014, the IRS decided to allow investors the option of putting the lesser of $130,000 or 25% of their tax-deferred funds into a deferred income annuity. As long as the deferred annuity meets certain requirements, the value of the annuity deposit would no longer be included in the value of an IRA or 401(k) for required minimum distribution (RMD) calculations. These are known as qualified longevity annuity contracts, or QLAC.
Looking at the math, you’re thinking that $130,000 might not make a big difference in the RMD calculation. You’re right—it doesn’t. On average, RMDs are around $5,000 less. That might be enough to keep an investor out of a higher tax bracket, but it isn’t saving a meaningful amount in taxes. So why bother?
Let’s first remember that annuities are not for everyone. An annuity is a contract between an investor and, usually, an insurance company. The basic principle is that the investor pays a premium in exchange for future periodic payments. These are tools to be used inside a structured plan to minimize an identified risk. In the case of QLACs, the risk is the chance an investor will outlive his assets.
When QLACs are purchased, the investor sets the structure for his future income stream. For example, let’s say a 70-year-old investor with limited savings wants to defer the payments until he is age 80. He invests $100,000 in a deferred annuity that qualifies as a QLAC. The annuity guarantees an annual income stream of $19,400 beginning at age 80. At age 71 ½, that $100,000 is not counted in his RMD calculation. However, because our investor has limited savings, he will likely withdraw more than the required amount from his retirement account. The “argument” of using a QLAC to defer or minimize RMDs is moot.
For the next 10 years, the annuity does not grow. The payout structure he agreed to—$19,400 a year—is still in effect, regardless of market conditions or inflation. However, once he reaches age 80, he will receive these payments for as long as he is alive. That is the protection against the investor’s longevity.
The investor will need to live at least five years to receive his principal back—longer if you consider the opportunity cost of not being invested in the market that would have allowed that $100,000 to grow. Should the investor die before he receives a payment from the QLAC, his heirs may not receive anything if there is no cash-balance option. If this investor lives to 90 or older, he will likely benefit from having the QLAC.
But, outliving the annuity contract is not the only risk. The annuity is guaranteed income, is based on the claims-paying ability of the issuing insurance company. He is betting that this insurance company will be solvent 20 years after he purchased the annuity product. He is also sacrificing a lower return than he may be able to get in the market for the guarantee of income—but that is another article for another day.
Generally, annuities work best when used to transfer a single risk to the insurance company. It takes a specific set of circumstances for these tools to work to the investor’s advantage. Before you buy an annuity product, you should consult a financial adviser who is not selling the annuity product to evaluate your situation.
If you have questions on whether a qualified longevity annuity contract would work for you, the experts at Henssler Financial will be glad to help: