Key Takeaways
- A QLAC is a type of longevity deferred annuity that provides a guaranteed stream of income during one’s life span.
- It allows an exemption from RMDs and a continued deferral of taxes into the later years of retirement, up to a maximum age of 85.
- If someone is in fear of longevity risk and is in search of certainty, this may be an appropriate tool.
- If someone is more growth oriented and wants more flexibility of their assets in retirement, this may not be an appropriate tool.
The American dream is the idea that anyone can achieve their version of success, and that we live in a society that allows upward mobility in our pursuit of happiness. So, it becomes of no great surprise that one of American’s biggest worries revolves around this very concept. Nearly two-thirds of American’s greatest fear is that they will run out of money before they die.
Additionally, the ability of Social Security to handle the burden of the retiring population is at serious risk. The Social Security trust fund is set to begin its depletion by 2035. Luckily, there is a relatively new investment vehicle that can combat this very downfall, the Qualified Longevity Annuity Contract (QLAC).
What Are Qualified Longevity Annuity Contracts (QLACs)?
A QLAC is a type of deferred annuity that provides a guaranteed monthly income until one’s death. Before we continue, let’s now define the term – deferred annuity. This type of annuity is a contractual agreement where, upon an initial lump-sum premium, one is provided a fixed income at a chosen future date. Now, the source of this premium payment must be qualified money. This is nothing more than a fancy term for any money from a retirement account. Types of plans that can fund our QLAC include Traditional Individual Retirement Accounts (IRAs) and employer sponsored retirement plans such as the 401(k), 403(b) and the 457(b).
It’s important to understand that the 401(k) needs to roll into an IRA before purchasing the contract. In essence, you are buying a pension plan for yourself, insuring that you will not outlive your money.
What Are the Financial and Tax Benefits of a QLAC?
As mentioned, the monthly distribution is deferred until a future date. During this deferral period, the insurance company will invest the money on your behalf. The longer the waiting period and the higher the initial premium, the greater the monthly payout. This is a big deal because you are protecting yourself from market fluctuations and ensuring that the money will hit your bank account.
Note, the highest premium one can purchase is $200,000 per individual. If you are married, each spouse can reach this limit. In regard to the premium source, we are using deferred retirement funds. This helps us capitalizing on important tax benefits. By keeping the money in the tax deferred shell, individuals nearing retirement are delaying and mitigating a tax burden at a time where income is statistically the highest. We are also leaning into compounding interest that exponentially grows the assets.
Moreover, because this money has never been taxed, one’s monthly income payments will be fully taxable at their ordinary tax rate. That said, the end goal is to experience this tax liability in retirement, at our lowest possible tax rate. If the participant were to pass away, the premium will be returned to the beneficiary unless any distributions are already made. This can either be in a lump sum distribution or through periodic payments.
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How QLACs Are Unique
We are at a point where we understand the basics of a QLAC and how it operates, but what makes this type of product unique is equally as important. QLACs are exempt from the Required Minimum Distribution (RMD) rules.
An RMD is a specific amount of money that one must take from a retirement account starting at a certain age. The amount of money that must be withdrawn is based on the amount of assets and one’s age. The IRS has charts and calculators that can assist anyone in understanding their RMD. A QLAC proves very valuable because it allows retirees to defer paying taxes until they begin receiving their monthly income at a much later age. Effectively, you are pushing off RMDs which currently start at age 73, and deferring payments up to an allowable age of 85.
Enhancing Retirement Security With a QLAC
To illustrate the potential benefits of a QLAC in securing your retirement, consider the following example:
Consider a single individual, age 65, with $650,000 in an IRA. They are concerned that they will outlive their money. We know that they need $4,000 a month to live, and their investment will return 6% net of inflation annually. Let us also assume that they have no other source of income and are in the 25% tax bracket. By age 92, they will have completely drained their assets.
Now, if this individual took $100,000 of the initial IRA amount and bought a QLAC with a $4,000 monthly payment, they could activate this contract around age 85. At this point, the investor has successfully ensured that they will continue living the retirement they imagined.
Also, by transferring $100,000 into this type of annuity, the investor saved $25,000 in tax payments which, instead of paying the IRS, went to their premium. As stated before, a higher premium leads to a higher monthly payout.
Optimizing Retirement With QLACs
Due to the relatively illiquid nature of a QLAC, purchasing a product like this needs to be taken with care. It’s important to note that a QLAC is merely another tool that should complement one’s financial plan. The amount that someone should place in this product needs to coordinate with the usage of their assets. There should be a balance between your retirement investments, your Social Security income and the utilization of a QLAC to supplement the difference needed. It’s important to consult with your financial advisor about its incorporation.
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Factors To Consider and Potential Risks
At this point, we are probably thinking that an annuity like this is a no brainer for everyone, but we need to look at every angle of this product.
There as some cons (or compatibility measures) we need to address first. Stated plainly, this is an illiquid investment. If someone feels that they will need great flexibility with their assets in retirement, this might not be the product for them.
Additionally, for those prioritizing growth, a QLAC may not provide the desired level of financial leverage. QLACs offer a minimum rate of return that, at times, can struggle to keep up with inflation.
Lastly, it’s essential to note that the QLAC has a capped contribution limit, necessitating a careful evaluation of income versus expenses. It’s important to sit down and properly understand one’s needs to know whether a product like this is the right tool.
Is a QLAC Right for You?
Before committing to a QLAC, it’s important to assess whether this type of annuity is suitable for you.
QLACs are ideal for individuals worried about outliving their investments, lacking faith in Social Security, seeking certainty, risk-averse, in good health and preferring tax deferral.
However, QLACs are not suitable for individuals seeking growth, requiring asset flexibility in retirement, trusting in Social Security and other assets for retirement expenses or having a shorter time horizon due to poor health.
In the end, whether a QLAC suits you hinges on a range of personal and financial factors that determine its suitability for your circumstances.
Frequently Asked Questions About QLACs
The downside risks of purchasing a QLAC include limited liquidity until annuity payments begin, potential loss of remaining funds if the annuitant passes away prematurely and the risk of inflation eroding the value of fixed payments. Additionally, there’s a risk of default on annuity payments if the issuing insurance company experiences financial instability.
The age at which someone should purchase a QLAC depends on various factors, including their retirement goals, financial situation and health. However, considering that QLACs allow for deferral of income until a later age, individuals typically purchase them closer to retirement, typically between ages 60 to 70, to maximize their benefits and ensure financial security in later years.
The maximum investment allowed in a QLAC is $135,000 or 25% of your retirement account balance, whichever is less. This limit applies per individual, meaning if you’re married, each spouse can contribute up to this limit. It’s important to consider this cap when planning your retirement income strategy.
Death benefits from a QLAC are typically paid out to beneficiaries either as a lump sum distribution or through periodic payments, depending on the terms of the contract. However, any distributions already made may affect the amount received by beneficiaries.
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