Personal Finance

QLACs Can Deliver Late-in-Life Income

"The strongest of all warriors are these two--Time and Patience." Leo Tolstoy was writing about real blood-and-guts combat in his novel War and Peace. But the same can be said about the battle for financial security in retirement. Every good soldier knows that the key to victory is saving early and often. But a relatively new tool, the qualified longevity annuity contract, or QLAC, can pay off for latecomers.

See Also: Are Annuities Right for You?

Imagine, a 60-year-old man invests $125,000 of his IRA money in a QLAC that won't pay him a dime until he reaches age 85, 25 long years from now. That's where the time and patience comes in. The payoff: Starting at age 85, the annuity will open an income stream of $60,000 a year, every year, for the rest of his life. No matter how long he lives. If he lives to 95, that $125,000 beachhead will return $600,000 to cover his late-in-life bills. A 65-year-old woman who invests $125,000 in a QLAC and waits 20 years for payments to begin will receive monthly payments of $3,300, or nearly $40,000 a year.

Such eye-popping numbers were expected to generate white-hot interest in QLACs when they were authorized by the federal government two years ago. But, so far, savers aren't rushing to buy this IRA-friendly version of the deferred-income annuity (DIA). In the first quarter of this year, just $87 million of the $729 million invested in deferred annuities went to QLACs, according to LIMRA, a life-insurance company trade group. Part of the reluctance is that today's record-low interest rates are built into returns. But IRA expert Ed Slott says he thinks a bigger reason may be that people "simply don't understand how this relatively new product works."

QLACs were created in 2014 to get around the IRS's rules that force owners of traditional IRAs and 401(k)s to begin taking required minimum distributions (RMDs) when they reach age 70. If you were to invest in a regular DIA, payments would have to start at 70 to be counted as part of your RMD. If you wanted to wait until 80 or 85, you'd have to dig deeper into other IRA assets to satisfy the withdrawal demands.

That's where the qualifying part of QLAC comes in. When certain rules are followed, the government lets you ignore the amount invested in a QLAC when figuring how much to withdraw from your IRA. The key requirements: Your total investment in QLACs may not exceed the lesser of $125,000 or 25% of the total balance in your IRAs and company retirement plans such as 401(k)s; payments must begin no later than age 85; and the payment at the income-start date must be guaranteed at the time you buy the annuity.

If you have $500,000 in an IRA at age 70 and $125,000 of it was in a QLAC, for example, your RMDs would be based on $375,000. In most cases, that would reduce your first RMD from $18,248 to $13,686, putting off the tax bill on nearly $5,000 that can continue to grow inside the IRA. Holding down RMDs is especially appealing to retirees who don't need the money and are rankled by having to pay the tax tab when they simply move assets from an IRA to a taxable account.

The tax bill is only delayed, though. Once the QLAC income stream kicks in, the cash counts as taxable income on top of your continuing RMDs.

The Known Unknowns

Two factors make it literally impossible to know if a QLAC will pay off for you: your life expectancy, and how inflation will play out over the next 20 to 30 years.

If you focus on average life expectancies, you may be reluctant to buy a QLAC at age 65 that delays payments until age 85. Frankly, a lot of folks who celebrate their 65th birthday won't be around for their 85th. The Social Security Administration says the average life expectancy of a 65-year-old man is 19.3 years (to about age 84); for a woman, it's 21.6 years (to just over 86). But those are averages. Social Security says one in four 65-year-olds will live past 90, and that one in 10 will live past 95.

Because there's no guarantee how long you'll live, there can be no certainty about how much you'll collect. And, just what the payments will be worth a decade or two in the future is another mystery. Although inflation has been behaving itself recently, if the long-term average of 3% were to reassert itself over the next 20 years, today's $100 would be worth just $55.

As appealing as guaranteed lifetime income is, the other side of the coin is worrisome. The income stops when you die. If a serious accident or illness results in a premature death, the stream of income could dry up long before you've collected as much as you paid for the annuity. That's the risk you take in exchange for the insurance company taking on the risk that you might live and collect checks much longer than expected.

But there is a way to hedge your bets. The QLAC rules allow the annuity to include the promise that you, or your heirs, will recoup at least the full cost of the annuity. If you die before the payment-start date, your heirs receive 100% of the premium. If you die after receiving some payments but not 100% of your investment, your heirs get the balance. The QLAC rules also allow a contract to provide for joint annuitants. If the insurer you pick offers this choice, you could arrange for the payments to continue after your death to someone else. Some plans even include cost-of-living escalators that boost the payments to keep up with inflation.

Slott is quick to point out that adding such "bells and whistles" to a QLAC reduces the lifetime benefit. "An annuity is one pot of money," he says. "If you want more during life, your heirs will get less after death."

Take the case of a 65-year-old man who invests the maximum $125,000 in a QLAC that will start payments when he is 85. For the maximum payout, he opts for the annuity to cover his life only, with no death benefit. The payments would be $50,000 a year. If he adds a death benefit to insure that either he or his heirs get at least $125,000, the annual payment starting at age 85 would drop to $37,375. And if he chose both a death benefit and for the annuity to cover both his life and his now 65-year-old wife's, it would dip to $27,360.

How do you decide? One way to answer that question, Slott says, is to first answer this one: "What's more important to you, not running out of money during your life or leaving money for your kids and grandkids?" Of course, it also depends on your other resources, both for paying bills and leaving a legacy.

Jerry Golden, a longtime insurance company executive and annuity expert, opted not to take a death benefit when he purchased a QLAC with IRA assets last year at age 71. The $125,000 policy will deliver about $40,000 a year in payments starting when he reaches 85. He plans to use the money to fund soaring late-in-life premiums on a life insurance policy that's part of his estate plan. He's currently paying much lower premiums on that policy and, if he dies before age 85, the insurance will provide the funds for his estate.

Golden's firm, Golden Retirement Advisors, created to help consumers shop for QLACs. If you're interested in a QLAC, you've got homework to do and may need the help of an adviser. Golden emphasizes that the first step is to design the policy. Death benefit or no? Single or joint life? Cost-of-living adjustments or not? Then shop for the best deal.

LIMRA reports that 11 insurers now offer QLACs, and most of them are included in a helpful tool you'll find on Golden's website. (The estimates in this story were generated by that tool.) He says that when he runs test scenarios, he's found that five different firms have returned the best deals. "Obviously, companies look differently at interest rates," he says, "but they also have different views on mortality. They are very competitive, and the company that's best for one plan might not be best for another.

See Also: 3 Ways to Guarantee Retirement Income for Life

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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