As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
What is a longevity annuity?
A longevity annuity – also sometimes called a “deferred income annuity” (DIA) – is an annuity contract that provides no cash value or death benefits during a deferral period, and begins to make annuitized payments for life at the end of that period, if the annuity owner is still alive. For instance, the contract for a 60-year-old might provide that payments will not begin until age 85, but upon reaching that age payments will be made for life; due to the long deferral period and the accumulation of significant mortality credits, the payments that ultimately begin may be very large relative to the original payment amount.
The IRS has issued a private letter ruling explaining the tax treatment of a so-called longevity annuity. According to the IRS, a longevity annuity qualifies for favorable treatment as long as, on the deferral period end date, the contract’s contingent account value becomes the cash value and is accessible by the owner through:
(1) the right to receive annuity payments at guaranteed rates,
(2) the right to surrender the contract for its cash value,
(3) the right to take partial withdrawals of the cash value, and
(4) a death benefit.
The IRS has concluded that a longevity annuity is an annuity contract for purposes of IRC Section 72 because the contract is in accordance with the customary practice of life insurance companies and the contract does not make periodic payments of interest.
In support of its first conclusion, the IRS notes that insurance companies historically have issued deferred annuity contracts that, like longevity annuities, did not have any cash value during the deferral stage and did not provide any death benefit or refund feature should the annuitant die during this time. Thus, in the IRS’s opinion, survival of the annuitant through the deferral period is not an inappropriate contingency for the vesting of cash value and the application of annuity treatment to the proposed contract.
In reaching the second conclusion, the IRS has taken note of the fact that the longevity annuity (1) provides for periodic payments designed to liquidate a fund, (2) contains permanent annuity purchase rate guarantees that allow the contract owner to have the contingent account value applied to provide a stream of annuity payments for life or a fixed term at any time after the deferral period, and (3) provides for payments determined under guaranteed rates.
What is the difference between a longevity annuity and a deferred annuity?
A deferred annuity provides for an initial waiting period before the contract can be annuitized (usually between one and five years) regardless of whether the annuity’s maturity date is determined by the owner’s age. In contrast, a longevity annuity does not allow the contract to be annuitized until the owner reaches a certain age (usually around 85). Many taxpayers purchase traditional deferred annuity products with a view toward waiting until old age to begin annuity payouts, but they always have the option of beginning payouts at an earlier date.
In some cases, a longevity annuity will only provide benefits if the taxpayer outlives the age specified in the contract. Because of this, longevity annuities will often provide for a larger payout than traditional deferred annuity products.
Most taxpayers who purchase longevity annuities do so in order to insure against the risk of outliving their traditional retirement assets. The longevity annuity, therefore, functions as a type of safety net for expenses incurred during advanced age. Where a deferred annuity contract may be more appropriately categorized as an investment product, the primary benefit of a longevity annuity is its insurance value.
What is a qualified longevity annuity contract (QLAC)? What steps has the IRS taken to encourage the purchase of QLACs?
A qualified longevity annuity contract (QLAC) is a type of longevity annuity that meets certain IRS requirements that have been proposed in order to encourage the purchase of annuity products with retirement account assets. A QLAC is a type of deferred annuity product that is usually purchased before retirement, but for which payouts are delayed until the taxpayer reaches old age—typically payouts begin around age eighty or eighty-five.
In the usual case, if an annuity is held in a retirement plan, the value of that annuity is included in determining the amount of the account owner’s required minimum distributions. One of the primary benefits of a QLAC is that the IRS’ proposed rules allow the value of the QLAC to be excluded from the account value for purposes of calculating RMDs. Because including the value of a QLAC in determining RMDs could result in the taxpayer being forced to begin annuity payouts earlier than anticipated if the value of his or her other retirement accounts has been depleted, the IRS determined that excluding the value from the RMD calculation furthers the purpose of providing taxpayers with predictable retirement income late in life.
The amount that a taxpayer can invest in a QLAC and exclude from the RMD calculation is limited, however, to the lesser of $100,000 (as adjusted for inflation beginning in 2014) or 25% of the taxpayer’s retirement account assets. The annuity contract must also provide that annuity payouts will begin no later than the date upon which the taxpayer reaches age eighty-five.
For more tax stories and Tax Facts Q&A’s, check out ThinkAdvisor’s 21 Days of Tax Planning Advice for 2014 Special Report.