Using a QLAC to Stretch Your RMDs and Protect Against Longevity

The tax code allows you to defer taxes on your qualified retirement plans until you start taking withdrawals when you retire. As the term “defer” implies, the government intends to collect taxes on your retirement income at some point. To ensure that taxes can’t be deferred forever, it came up with the Required Minimum Distribution (RMD) provision. While it seems reasonable enough on its face, the RMD rule includes a very nasty penalty if it is not followed to the letter. Starting at age 70 1/2, if you fail to withdraw the proper amount, you will be charged a 50 percent penalty on the amount not withdrawn.

The problem for some retirees is the RMD, which is calculated by dividing their qualified plan balance by the remaining years in their distribution period, may be more income than they need. While they can reinvest their excess income from an RMD, they lose a portion of their future income in current taxes. Until recently, there was really no way around this.

How a QLAC Works

The Qualified Longevity Annuity Contract (QLAC) was created for the specific purpose of addressing the risk of longevity – outliving your income. A QLAC provides a guaranteed lifetime income in exchange for a capital investment, except that, instead of paying the income out currently, it is deferred for a period of time, usually about 20 years but no later than age 85.

Until recently, QLACs could only be purchased outside of a qualified retirement plan. That solved one part of the problem – ensuring sufficient lifetime income – but, the RMD problem remained. It was still possible to drain your retirement assets too quickly and, because an investment in a QLAC is irrevocable, it created the potential for a liquidity squeeze if the retirement assets were depleted before the QLAC income kicks in.

That part of the problem was solved recently when the government decided to allow QLACs to be purchased inside a qualified retirement plan. Under this new provision, when a QLAC is purchased using retirement funds, the year-end balance is reduced by the amount invested in the QLAC. The provision limits the amount that can be invested in a qualified plan to 25 percent of the plan’s balance or $125,000, whichever is less. This would then lower your future RMDs by an equivalent amount. The $125,000 cap may be adjusted for inflation.

For example, if, at age 74, you had 23.8 years remaining for distributions (based on the life-expectancy factor in the IRS’s Uniform Lifetime Table), and your IRA balance at the end of 2017 was $400,000, your RMD for 2017 would be $16,807. However, if you used $100,000 of your IRA balance to purchase a QLAC, your fund balance for purposed of calculating your RMD would be $300,000. That would reduce your RMD to $12,605.That reduction of more than $4,000 would continue throughout your life and, when you turn 85, the QLAC will start making guaranteed income payments.* In effect, by purchasing a QLAC inside your retirement account, you are able to defer a portion of your RMDs until age 85.

Planning Considerations for a QLAC

Planning for and protecting against longevity is fraught with uncertainty and the RMD rule doesn’t make it any easier for retirees. Having the ability to reduce your RMD by as much as 25 percent can make a difference for many retirees. However, that should not be your only consideration when purchasing a QLAC. While a QLAC is a way to ensure you have a guaranteed lifetime income stream, it may not be suitable in all situations. Planning with a QLAC can be complicated, which is why it is important to seek guidance from a retirement planning specialist.

*Distributions from a QLAC must start no later than the first day of the month following annuitization, which can be no later than age 85.

The Breakdown

• The Required Minimum Distribution (RMD) provision forces retirees to withdraw a portion of their retirement assets starting at age 70 ½ whether they need the income or not.

• Taking RMDs when the income is not needed, creates an additional tax burden and reduces the availability of assets needed for future income.

• Qualified Longevity Annuity Contracts (QLACs) were developed as “longevity insurance” to protect against the possibility of outliving your income.

• Capital invested in a QLAC is used to generate a guaranteed lifetime income, but the payment period is deferred until a later age (no later than age 85).

• Recently the government allowed QLACs to be purchased inside 401(k) plans and traditional IRAs with the effect of reducing the amount of assets subject to the RMD calculation thus reducing the RMD each year.

• Using a QLAC to reduce RMDs can involve complex planning requiring the guidance of a retirement planning specialist.