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), and during that period the contract’s cash value generally remains liquid and available. Beyond the initial waiting period the contract may be annuitized, though the choice remains in the hands of the annuity policy owner, at least until the contract’s maximum maturity age at which it must be annuitized.

By contrast, a longevity annuity generally provides no access to the funds during the deferral period, and does not allow the contract to be annuitized until the owner reaches a certain age (usually around 85).

In other words, 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. With a longevity annuity, there is generally no choice, but this also allows for larger payments for those who do survive to the starting period; as a result, for those who survive, longevity annuities typically provide for a larger payout (often, much larger) 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 (“deferred income annuity”) that meets certain IRS requirements that have been developed 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.

In the usual case, if a deferred annuity is held in a retirement plan, the value of that contract is included in determining the amount of the account owner’s required minimum distributions (RMDs). One of the primary benefits of a QLAC is that the IRS’ 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 $125,000 (as adjusted for inflation in future years) or 25% of the taxpayer’s retirement account value. The final regulations provide that the 25% limit is based upon the account value as it exists on the last valuation date before the date upon which premiums for the annuity contract are paid. This value is increased to account for contributions made during the period that begins after the valuation date and ends before the date the premium is paid. The account value is decreased to account for distributions taken from the account during this same period.

To qualify as a QLAC, the annuity contract must also provide that annuity payouts will begin no later than the first day of the month following the month in which the taxpayer reaches age 85. Variable annuities, indexed annuities and similar products may not qualify as QLACs unless the IRS specifically releases future guidance providing otherwise. Further, a QLAC cannot provide for any commutation benefit, cash surrender value or similar benefit.

What types of retirement accounts can hold a qualified longevity annuity contract (QLAC)?

A qualified longevity annuity contract (QLAC) may be held in a qualified defined contribution plan (such as a 401(k) plan), IRC Section 403 plans, traditional IRAs and individual retirement annuities under Section 408, and eligible IRC Section 457 governmental plans.

An annuity purchased within a Roth IRA cannot quality as a QLAC. If a QLAC is purchased under a traditional IRA or qualified plan that is later rolled over or converted to a Roth IRA, the annuity will not be treated as a QLAC after the date of the rollover or conversion. While it is true that an annuity purchased in a Roth IRA cannot qualify as a QLAC, it should not be assumed that a Roth IRA cannot purchase a longevity annuity. The final regulations do not prohibit this.

Can a taxpayer purchase both QLACs and non-QLAC deferred income annuities (DIAs) within an IRA and remain eligible to exclude the QLAC value when calculating RMDs? How is the non-QLAC deferred income annuity treated in such a case?

The regulations answer this question by their focus: only QLACs are addressed within the regulations. IRA-held DIAs that are not QLACs are not governed by the new regulations. These regulations are additive in that they do not remove any of the previously existing rules that govern these types of annuity contracts. As a result, the regulations do not prevent a taxpayer from holding a non-QLAC DIA in a traditional IRA. In such a case, the previously existing method for determining RMDs for non-QLAC DIAs will apply.

— Related on ThinkAdvisor: