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Your questions about qualified money, RMDs and QLACs answered

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A big problem confronting those with significant retirement savings is that the money that they have accumulated is “qualified” money (sometimes abbreviated “TQ”). That is, money that has “grown” without being reported on the annual tax report to the IRS. Upon reaching 70½ years old, the IRS requires at least minimum distributions from those retirement accounts.

In other words, the IRS is saying, “OK, we’ve allowed you to earn money for retirement without paying taxes on the gains all these years. Now, it’s time take some of that money for your retirement years, pony-up, and pay us (their middle name is, after all, ‘revenue’) on that formerly income-tax free account.”

In July 2014, however, the Treasury Department released the final regulations allowing for the creation of a Qualified (money) Longevity Annuity Contract or QLAC. These new annuities will offer a unique tool to help people avoid outliving their money. It will also help people avoid having to take the required minimum distribution (RMD) from the qualified account, allowing all or part of the money to retain value and continue growth.

The QLAC rules, however, are a complicated mash-up of IRA and annuity rules, and people may need substantial help in understanding their key provisions. It is highly recommended that, if you are a consumer, you talk to your tax advisor, and if you’re an advisor, encourage your clients to talk to their tax advisor if you don’t offer these services. Consumers are strongly encouraged to contact an annuity sales or consultant professional prior to attempting to set up a QLAC.

Below are five critical QLAC questions and their answers, as they exist at this date.

So, what are QLACs? 

QLAC stands for qualifying longevity annuity contract, a new type of fixed longevity annuity. A longevity annuity is a relatively new concept in that the person buys an annuity (single-premium immediate annuity or SPIA), but postpones taking the income stream until some specified time in the future to avoid the risk of running out of money. Since the contract holder has given up the money in exchange for an income stream, there is technically no account value from which to take RMDs, so, none are due at 70½.

The contract itself is held in a retirement account and has special tax treatment. Distributions from QLACs don’t have to begin until a client reaches age 75, 80 or 85 (depends on how the contract is designed), well beyond the ages at which RMDs normally begin. The older one gets, the higher the payout rate of the annuity — it’s like a phantom account in which the value has “grown” over time.

When payments do begin, however, the entire distribution is income-taxable at the then-current tax rate. Tax laws can change and differ state to state. A qualified tax advisor should be consulted before purchasing a QLAC.

Why did the Treasury Department create QLACs?

Since 70½-year-olds might not need or want to take RMDs, they had few choices in avoiding RMDs for qualified (tax-deferred) retirement money. And, the choices they did have were challenging due to the tax-favored treatment of qualified money.

Without going into the technical details, without the QLAC, qualified account holders needed to:

1) Begin taking distributions (RMDs) from their qualified retirement accounts, reducing their account value and, by extension, their potential future monetary benefit, or…

2) Start taking an income stream now (“annuitize” the account), which would obviously produce a lower income stream than it might if they were to postpone taking an income stream until later at a more advanced age, or…

3) “Make-up” the RMDs from other qualified account assets, drawing down those assets at an accelerated rate. None of these options was particularly attractive and now, thanks to QLACs, clients will no longer be forced to make such decisions.

Can one roll all qualified retirement savings over to a QLAC?

You already knew the answer to this, right? No. Basically you are limited to a rollover of 25 percent or $125,000 of your total qualified assets, whichever is less. (It’s more complicated than this, so see “Limitations Details” on the next page.)

What happens if a person dies before or during a QLAC payout?

A QLAC may offer a return of premium death benefit option, whether or not a client has begun to receive distributions. Any QLAC contract offering a return of premium death benefit must pay that amount in a single, lump-sum, to the QLAC beneficiary by December 31st of the year following the year of death. (One would assume that it would happen more quickly than that.)

Such a feature is available for both spouse and non-spouse beneficiaries. In addition, the final regulations allow this feature to be added regardless of whether the QLAC is payable over the life of the QLAC owner only, or whether the QLAC will be payable over the joint lives of the QLAC owner and their spouse.

QLACs may also offer life annuity death benefit options. In general, a spousal QLAC beneficiary is eligible to begin taking a payout from the contract if the QLAC owner has not started taking payments yet. A beneficiary does not have to do this, however, and can continue the non-payment period to comply with ERISA rules.

If the QLAC beneficiary is not the spouse of the QLAC owner, the rules are more complicated. At the time of the sale of the QLAC, the contract owner has to choose between two settlement options at death:

1) There is no guarantee a non-spouse beneficiary will receive anything.

2) Guarantee payments to a non-spouse beneficiary will be made, but those payments will be comparatively smaller than if payments were received by a non-spouse beneficiary under the first option.

Put in simplest terms, a non-spouse beneficiary receiving a life annuity death benefit will generally fare better with the first option if the QLAC owner dies after beginning to receive benefits whereas, if the QLAC owner dies before beginning to receive benefits, they will generally fare better with the second method.

This puts some pressure on the contract buyer because neither outcome can be predicted with any certainty. We may see some adjustment to this in future QLAC death benefit rules as the product evolves.

Can one purchase a QLAC now if they are getting close to RMD age?  

Yes, but carriers offering such contracts are limited. QLAC regulations are in effect, but few carriers have rushed to market with QLAC contracts. Major early entrants with QLAC contracts are AIG and Lincoln National. What additional carriers will offer them and exactly which features those carriers will choose to incorporate into their products remains to be seen.

If such products fit your situation, it probably makes sense to reach out to knowledgeable advising financial professionals (FAs, CFPs, Estate & Retirement Attorneys) now and begin the discussion. It may take a while to hammer out a QLAC design that is best for your particular situation.

QLAC Limitation details:

  • Roth IRAs can’t be considered for QLACs.

  • For traditional IRAs, the 25 percent limit is based on the total fair market of all traditional IRAs owned by the consumer, including SEP and SIMPLE IRAs, as of December 31st of the year prior to the year that the QLAC is purchased. The fair market value of a QLAC held in an IRA will also be included in that total, even though it won’t be for RMD purposes.

  • The 25 percent limit is applied in a slightly different manner to 401(k)s and similar plans. For starters, the 25 percent limit is applied separately to each plan balance. In addition, instead of applying the 25 percent limit to the prior year-end balance of the plan, the 25 percent limit is applied to the balance on the last valuation date. Then, that balance is further adjusted by adding in contributions made between the last valuation and the time the QLAC premium is made, and by subtracting from that balance distributions made during the same time frame.

  • In addition to the 25 percent limits described above, there is also a $125,000 limit on total QLAC purchases by a client. When looked at in concert with the 25 percent limit, the $125,000 limit becomes a “lesser of” rule. In other words, a client can invest no more than the lesser of 25 percent of retirement funds or $125,000 in QLACs.

NOTE: Although tax and legal issues may be part of this article, nothing herein constitutes legal or tax advice. Always seek the advise of qualified advising financial professionals before purchasing or selling any financial product.