Retiree tax planning with qualified longevity annuity contracts.

• Author: Blankenship, Vorris J.

As life expectancy in the United States continues to increase, more retirees have a new worry--outliving their retirement savings. In response to this concern, (1) the IRS recently issued regulations authorizing a new type of annuity contract for certain tax-favored retirement plans and IRAs. (2) The new contract is a qualified longevity annuity contract (QLAC).

The IRS designed QLACs to alleviate some of the risk that a retiree would outlive his or her retirement benefits. That risk is particularly acute for retirees who have retirement plans and IRAs that do not normally pay life annuities. (3)

For these plans or IRAs, the amount of the required minimum distribution (RMD) a participant must take each year generally depends on a participant's account balance. For each year beginning with the year the participant reaches age 70 1/2 (or later retirement in some cases), (4) the plan or IRA must distribute a minimum amount equal to the prior year's adjusted account balance divided by a distribution period. The retiree finds the distribution period each year by reference to his or her age in an IRS actuarial table. (5)

Example 1: R, a retiree, is age 73 on her birthday in the year 2014, and the adjusted account balance of her IRA was $400,000 at the end of 2013. R computes the RMD of $16,194 for 2014 by dividing the adjusted account balance of $400,000 by the 24.7 years found in the IRS table for a retiree age 73. For the following year, 2015, assume the adjusted account balance at the end of the last year was $420,000. R computes the RMD of $17,647 for 2015 by dividing the adjusted account balance of $420,000 by the 23.8 years found in the IRS table for a retiree age 74 (one year older). Since RMDs depend on the retiree's age, his or her account balance, and the IRS's actuarial tables, it is quite possible for a retiree to deplete or greatly reduce the funds in his or her plan or IRA before he or she dies. That is, a retiree may receive distributions over a longer period than anticipated because he or she lives longer than expected. Or the plan or IRA may suffer equity market losses or other plan losses that reduce the account balance.

Inadequacy of Past Solutions

In the past, a retiree might have hedged the risk of depleting retirement funds by having the plan or IRA use some of its initial account balance to purchase a deferred annuity. The deferred annuity could have provided that it would start payments when the retiree reached a specified advanced age (e.g., age 85).

Unfortunately, though, for the year the annuity began and all prior years, the then-controlling tax law required the retiree to include the actuarial value of the deferred annuity in his or her account balance. (6) Thus, early minimum distributions based on this inflated account balance were generally larger than desired. As a consequence, the retiree would often find it necessary to start deferred annuity payments earlier than planned, just to continue to satisfy the minimum distribution requirements. QLACs now offer a solution to this problem.

Definition and Requirements of a QLAC

A QLAC is a specific type of annuity purchased for a participant in a qualified defined contribution plan, a Sec. 403(b) plan, a Sec. 457 governmental plan, or an IRA (other than a Roth IRA). (7) The annuity contract must state that the contract is a QLAC. (8) It must start paying the annuity no later than the first day of the month coincident with or immediately following the participant's 85th birthday, (9) but it may also allow the participant to elect an earlier starting date. (10) In addition, the aggregate premiums paid for all QLACs benefiting a participant may not exceed certain dollar and percentage limitations described below. (11)

A QLAC generally must be payable over a retiree's lifetime or over the lifetimes of the retiree and a beneficiary. (12) The QLAC must also satisfy all the usual minimum distribution requirements for annuities (other than the requirement to begin payments by April 1 of the calendar year following age 70 1/2). (13) For example, the regular interval between the annuity payments may not exceed one year. And, subject to some specific exceptions, the amount of the annuity payments may not increase over the term of the annuity or upon the retiree's death. (14)

A QLAC cannot provide commutation benefits, cash surrender rights, guaranteed payments, or other similar features. (15) Nor may a variable or indexed contract qualify as a QLAC. (16) The only QLAC benefits allowed after a participant's death are life annuities paid to a designated beneficiary (or the return of premiums exceeding previous annuity payments to the participant). (17) A designated beneficiary is an individual entitled to benefits after the retiree's death who is designated as a beneficiary under the plan or arrangement. (18)

Advantages of a QLAC A QLAC significantly increases tax deferral by delaying annuity payments until an advanced age. Earlier minimum distributions are smaller than usual since the value of the QLAC is excluded from the account balance used to compute those distributions. (19) Most importantly, though, a QLAC provides some additional financial security for a retiree who outlives his or her life expectancy or suffers through a downturn in the equity markets.

The Dollar and Percentage Limitations on QLAC Premiums

Aggregate QLAC premiums paid during a participant's lifetime by all his or her plans and IRAs may not exceed $125,000 (adjusted for inflation). Also, the cumulative premiums paid by any one plan may not exceed 25% of the plan's account balance (including the value of any QLAC) on the date of a premium payment. (20) However, all of a taxpayer's IRAs are treated as a single plan for purposes of applying the percentage limitation. In addition, a participant must determine IRA account balances as of Dec. 31 of the year preceding the year of the latest premium payment. (21)

Example 2: R, a retiree, is a participant in plan M, a qualified defined contribution plan. Plan M owns a QLAC for which it previously paid a premium of $50,000. R also owns IRA./with an account balance of $125,000 and IRA K with an account balance of $75,000 (both balances determined as of the preceding Dec. 31). R wants IRA K to pay a premium of $45,000 for an additional QLAC. The premium paid by IRA K will satisfy the dollar and percentage limitations. The cumulative premium payment of $95,000 will be less than the $125,000 limit. The $45,000 premium payment by IRA K will also be less than the $50,000 percentage limitation (i.e., less than 25% of the $200,000 combined balances of IRAs J and K) An annuity contract acquired by paying a premium that cumulatively exceeds the dollar or percentage limitation cannot be a QLAC. Thus, the annuity contract to be acquired by IRA K in Example 2 would not be a QLAC if the premium exceeded 25% of the combined account balances of IRAs J and K Consequently, the value of the contract would be...