Saving for retirement is important, but it can be complicated. Even once you’ve finished saving and decide to stop working, the stress doesn’t go away. You have to think about managing your retirement savings, making sure you have enough money to last the rest of your life and deal with taxes.
Qualified longevity annuity contracts are one option for making sure you have a stable income stream while minimizing the tax burden of required minimum distributions.
What is an Annuity?
An annuity is a contract, usually sold by a financial institution or insurance company, that is a popular way for people to turn sums of cash into a stream of income. This makes them popular among people saving for retirement.
There are many varieties of annuities, each with unique characteristics. However, the most basic type of annuity is the immediate annuity, which involves paying a lump sum to a company in exchange for regular payments for a set period, such as for 10 years or the rest of your life.
For example, someone who is 65 years old and planning to retire may pay an annuity company $250,000 in exchange for monthly payments of $1,250 for the rest of their life. This gives the retiree a steady stream of income without the stress of worrying about market performance or managing the money. The annuity company, in turn, typically invests the money and is able to earn a profit from it in the long run.
In general, annuities are ideal for people who want guaranteed income or who want a way to hedge against longevity risk — the risk that you’ll outlive the money you’ve saved. This is because their payments are guaranteed by the company backing the annuity for as long as you live.
Required Minimum Distributions
When you turn 59 ½, you can begin taking distributions from your tax-advantaged retirement accounts for any reason. You’re not obligated to set up a schedule or take money out of the accounts, you can simply access the accounts as you need to.
Choosing when to withdraw money from your retirement accounts is important. The accounts you take money from and the amount you take can have significant tax implications.
For example, if you take $10,000 from a traditional IRA, that counts as taxable income. If you move into a higher tax bracket, a portion of that withdrawal will be taxed at the higher rate. If you instead withdraw less money from the traditional IRA and take some from a Roth IRA, you can remain in a lower tax bracket.
While younger retirees aren’t forced to take money from their retirement accounts, as you age, you will likely run into something called required minimum distributions (RMDs). Beginning with the year after you turn 72, you will be required to withdraw at least a portion of your savings from your retirement accounts.
You may be required to take at least a certain amount of money from your retirement account each year if you meet the following characteristics:
- You were 72 or older on January 1.
- You have money in an employer-sponsored retirement plan such as a 401(k), SEP IRA, or SIMPLE IRA, or have a traditional IRA.
If you’ve inherited an IRA, you’ll also have to take RMDs. RMDs for inherited IRAs follow special rules.
The goal behind RMDs is to make sure people can’t use retirement accounts to shield large amounts of assets from taxes. The formula for RMDs accounts for the age and life expectancy of the retiree, so the amount of money you must withdraw (as a percentage of your retirement account assets) will tend to increase as you get older.
The IRS has an RMD worksheet you can use to calculate your RMD for the year. You start by taking the value of your retirement accounts on December 31 of the previous year. Then, use your age on the IRS Uniform Lifetime table to determine the corresponding distribution period value.
Divide the account assets by the distribution period value to find your RMD.
For example, if you were age 70 and had $100,000 in your IRA on December 31 of the previous year, your distribution period would be 27.4, and your RMD for the year will be calculated as:
$100,000 / 27.4 = $3,649.64
The distribution period value decreases as you get older, meaning you’ll have to withdraw a larger portion of your 401(k) or IRA balance each year. For example, by the time you turn 80, the value is 18.7.
How a Qualified Longevity Annuity Contract Can Help Avoid RMDs
When you withdraw money from a traditional retirement account, whether as part of an RMD or by choice, you have to pay taxes. The larger your RMD, the more taxes you’ll have to pay on retirement account withdrawals.
A qualified longevity annuity contract (QLAC) lets you turn some of the money in your 401(k) or IRA into an annuity. This reduces your retirement account balance, reducing the amount you must withdraw as an RMD. and provides you with a steady stream of retirement income.
How it Works
A QLAC is a type of deferred income annuity. That means that when you purchase a QLAC, you don’t immediately receive income from the company selling the annuity. Instead, you must wait a period of time before payments begin.
When you buy a QLAC, you use money in one of your retirement accounts to purchase the annuity. The IRS does not consider the money spent on the annuity as withdrawn from your retirement account, meaning you don’t have to pay taxes on it. However, because buying a QLAC reduces the balance of your retirement account, your RMDs will be smaller.
You’ll pay income tax on the payments you receive from the QLAC when you start receiving them. In a way, this lets you defer a portion of your RMDs because you’ll be required to receive (and pay taxes) on the annuity payments once they begin.
Rules and Requirements
Almost anyone who has a retirement account is eligible to buy a QLAC. The only accounts that are ineligible are inherited retirement accounts and Roth IRAs. However, to follow IRS rules, QLACs must meet a few requirements.
First, you cannot defer payments from a QLAC past age 85. You don’t need to choose a deferral period that long, but you can’t, for example, buy a QLAC that doesn’t begin making payments until you turn 90.
Second, there is a limit to the amount you can spend to purchase the QLAC. You can spend the lesser of 25% of your account balance or $135,000 on the annuity. This limit applies across accounts and per lifetime. You can’t get two QLACs costing $135,000 each, one from IRA funds and one from 401(k) funds.
Benefits of Qualified Longevity Annuity Contracts
QLACs are great for many different retirement planning situations.
1. Reduce Your RMDs
One of the primary reasons to buy a QLAC is that they reduce the balance of your IRA or 401(k). This reduces the amount you have to take from your retirement accounts as part of RMDs, giving you some more control over your tax situation early in your retirement.
2. Longevity Insurance
The regular income a QLAC provides can provide some extra insurance if you wind up with a longer than expected retirement. If you’re relying on the balance of a retirement account, there’s the possibility that you will run out of money before you die, especially if you live longer than you planned.
Having a lifetime income stream that can supplement Social Security and that’s guaranteed to last the rest of your life can reduce that risk.
3. Protection for Loved Ones
You can purchase a QLAC that also offers benefits for your spouse. For example, a joint-life annuity can continue to make payments even after you die to provide your spouse with income through the remainder of their retirement.
Drawbacks of Qualified Longevity Annuity Contracts
QLACs aren’t perfect. It’s important to know their drawbacks before you commit to purchasing one.
1. Inflation risk
While buying an annuity saves you from some types of risk, such as the risk of your investments losing value, it introduces other types of risk. One type of risk with annuities is inflation.
A fixed annuity offers fixed payments that do not adjust for the cost of living or inflation. If inflation spikes before or during the period you receive payments, the money you receive might have much less purchasing power than you expected.
2. Less Flexibility
When you buy a QLAC, you give a company money now for a benefit later. You can’t turn around and ask for your money back if you wind up wanting or needing it before your annuity payments start.
If you keep your money in a retirement account instead of buying an annuity, you’ll have higher RMDs but more freedom to use that money when and where you want to use it.
3. Lower Returns Over the Long Run
When you buy an annuity, you exchange a sum of cash for a fixed income stream. In most cases, the long-term value of your annuity will be less than the amount you could have made by investing the money you paid for the annuity.
Most companies price annuities so that they can invest the money you pay and come out ahead, even after giving you your regular payments.
4. May Reduce the Value of Your Estate and Inheritances for Heirs
Unless your annuity included a death benefit, benefits for a surviving spouse, or a guaranteed minimum benefit, the company that sold your annuity will stop making payments when you die. This is true whether you’ve received one payment or 100.
Your heirs won’t get a payout or be able to inherit the annuity from your estate. If you had kept the money you spent on the annuity in your retirement accounts, your heirs would be able to inherit the remainder when you died.
These are some frequently asked questions about QLACs.
Are QLAC Payments Taxable?
Yes, any income payments you receive from a QLAC are considered taxable income. You have to pay income taxes on it as you would for any other form of income.
Who Sells QLACs?
You can buy annuities, including QLACs, from many different companies. Insurers and financial companies are two of the most common types of businesses that sell annuities.
What Determines The Payment You Get From a QLAC?
Companies determine annuity payments using complex formulas that account for factors like your health, age, and life expectancy. In general, the more you pay for an annuity and the longer you wait before taking payments, the more you’ll receive with each payment.
QLACs are a retirement planning tool that can provide long-term insurance in the form of a steady stream of income. They’re also a handy way to defer taxes by letting you reduce the RMDs you must take from retirement accounts.
Even if you don’t think an annuity is right for your personal situation, it’s worth looking into the different types that are available. There are many different styles of annuities, including annuities that offer guaranteed benefits, support for spouses, or escalating payments in certain situations, so it’s worth it to explore your options.