It was only a few months ago when the U.S. Treasury Department issued final regulations for Qualifying Longevity Annuity Contracts (QLACs) in employer-provided retirement plans and IRAs. These plans can now purchase deferred income annuities where an annuitized payout can start as late as age 85 (Treas. Reg. 1.401(a)(9)-5 and Treas. Reg. 1.401(a)(9)-6)

Participants in 401(k) plans or IRAs can now use up to 25 percent of their account balance or $125,000 — whichever is less — as a premium to buy a QLAC. The new regulations exclude the annuity value from the account balance that is used to determine the Required Minimum Distribution (RMD) that participants must start receiving at age 70 ½.

These new QLACs will help Americans plan for retirement and assure they have a continuous stream of income for as long as they live. The new QLAC rule also applies to other defined contribution plans (i.e. profit sharing plans and SEP plans), 403(b) plans, and governmental 457(b) plans). This will give those approaching retirement an opportunity to “carve out” an amount that will not be subject to the RMD rules at age 70 ½.

Let’s take a look at some of the major provisions of the new regulations for deferred income annuities to be considered QLACs:

Lifetime QLAC considerations:

  • In addition to the lesser of $125,000 or 25 percent of account balance premium rule, a QLAC must not begin distributions later than attainment of age 85. Distributions may begin prior to age 85. 
  • The $125,000 amount will be periodically indexed for inflation in increments of $10,000. The 2016 indexed QLAC amount remains at $125,000.
  • The $125,000 is an aggregate limit that applies to all defined contribution plans and IRAs of an individual.
  • Although the value of the QLAC is excluded from the account balance to determine RMDs, the value of the QLAC account balance is included for purposes of applying the 25 percent limit.

QLAC considerations after death:

  • A QLAC may offer a return of premium (ROP) feature that is payable before and after the annuity starting date prior to age 85.
  • The QLAC may provide a single sum death benefit paid to a beneficiary in an amount equal to the excess of the QLAC premium payments over and above the cumulative payments made to the participant.
  • If the QLAC is providing a life annuity to a surviving spouse, it may also provide a similar ROP benefit after the death of both the participant and spouse.

Other QLAC requirements:

  • A QLAC does not include a variable annuity contract or an indexed annuity contract.
  • The QLAC contract is not permitted to make available a commutation benefit or cash surrender value.
  • The language of the deferred annuity contract must clearly identify the contract as a QLAC within the contract, a rider or an endorsement.
  • Multiple QLAC contracts are permitted, but the cumulative premium for all contracts cannot exceed the lesser of the $125,000 indexed premium amount or 25 percent of account balance rule.
  • The final QLAC regulation does not apply to defined benefit plans since these plans generally offer an annuity payout, which already provides longevity protection.

Transfers or exchanges into QLACs:

  • If after July 2, 2014, an existing contract is exchanged for a contract that satisfies the requirements for a QLAC, the new QLAC will be treated as purchased on the date of the exchange. In this case, the fair market value of the contract that is exchanged for a QLAC is treated as a premium amount that counts toward the QLAC limit.

Hypothetical case study: When QLACs are made available for sale by carriers

The client is 65-years-old and is actively involved in planning for retirement. An existing mutual fund IRA of $625,000 is invested in a portfolio of equities and fixed income assets consisting of corporate bonds and U.S. government securities. The client feels he won’t need to spend all of the RMD that will be required to be distributed at age 70 ½. In addition, the client and spouse expect to receive about $45,000 per year of Social Security benefits and $24,000 per year from a defined benefit pension from a prior employer. They have about $250,000 of other non-qualified liquid assets. The client asks if there is a way to allocate part of the IRA into a financial asset where he won’t be required to take income until a later date. What strategy might you recommend?

You should suggest that the client consider “carving out” $125,000 and placing it into a QLAC IRA deferred income annuity, which will start lifetime payment at age 85 with a guarantee of 15 years. The features of the plan are as follows when QLACs are available for sale:

  • The $125,000 QLAC IRA will not be subject to RMDs at age 70 ½.
  • Starting at age 85, the client will receive a lifetime payout of $23,293 per year with a guaranteed payment period of 15 years.
  • If the client dies during the 15-year period after age 85, the designated beneficiary of the client (spouse or non-spouse) will receive the remaining guaranteed payments.
  • If the client dies prior to age 85, the designated beneficiary will receive the original amount of $125,000 as a taxable lump sum death benefit.
  • Payments from the QLAC IRA deferred income have a $0 cost basis so they are fully taxable as ordinary income to the client during lifetime. And any lump sum death benefit paid to the designated beneficiary prior to age 85 is also fully taxable as income in respect of decedent (IRD) to the beneficiary.

Remember, the carrier will have to include QLAC language in the body of the contract, a rider or an endorsement so that the deferred income annuity contract is considered to be a “qualified” contract.