QLACs: A Secret Weapon to Help Reduce RMDs

If you are one of many Americans who have salted away large sums of money in 401(k)s and IRAs, you face a tax dilemma. Once you retire, you must generally start taking required minimum distributions (RMD) when you reach age 70½. And the amount, determined by an IRS formula, can be substantial. For example, if you have $1 million in an IRA or 401(k), you must withdraw $36,496.35 at age 70½.

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This will have an impact on your adjusted gross income and could trigger higher federal income taxes, a possible increase in Medicare premiums, as well as taxation of up to 85% of Social Security benefits.

If you don’t want or need the RMD to support your lifestyle, there are only a few options to help avoid this ticking time bomb. One fairly new one is a qualified longevity annuity contract. A QLAC allows retirees to keep some of their tax-deferred savings aside, untouched and growing tax-free, as they start taking their required minimum distributions.

A QLAC is an insurance product that offers a guaranteed stream of income in exchange for an upfront payment. You can take 25% from your retirement plan assets, such as your IRAs and 401(k) — up to $125,000 for an individual or $250,000 for a couple — to fund your QLAC, and you can defer that money until a maximum age of 85.

I think of the QLAC as a secret weapon, because so few consumers seem to know much about it. But it’s only been around since 2014. I predict it will grow more popular as word spreads.

Here are some ways a QLAC might fit into your retirement plan:

• As a tax-saving strategy: If you’re closing in on 70½ and worried about the effect that required minimum distributions (RMDs) will have on your taxes, a QLAC can soften the blow. Let's say you have $500,000 in your traditional IRA, and you put $125,000 in a QLAC. Your RMD will now be calculated on $375,000 instead, potentially lowering your taxes.
• As a hedge against longevity risk: One of the goals of the QLAC is to help retirees deal with worries about outliving their savings. According to the Social Security Administration, a man reaching age 65 today can expect to live, on average, until age 84.3. A woman turning 65 today can expect to live, on average, until age 86.6. That’s a long time to need to make your money last. Your QLAC will be there when you reach 85 (or whatever age you choose to defer it to). If you are married, you can elect a joint and survivor 100% payment with cash refund. This would guarantee the payment from the QLAC for both spouses’ lifetimes, and a cash refund guarantees your beneficiaries to receive no less than the amount you deposited into the QLAC minus the income payments.
• As a replacement for an employer pension: QLACs are always a fixed annuity that guarantees a stream of income, much like Social Security or a pension. Annuities pool funds, so if you live a long life, the amount you receive may add up to be more than if you had saved the money on your own. These are fixed annuities; they don’t include variable annuity or equity indexed contracts, so your principal is protected (it is backed by the financial strength of the insurance company that sold it). And to sweeten the pot, some carriers allow you to attach a contractual cost-of-living adjustment (COLA).
• As an opportunity to leave a legacy: Much like a pension, a death benefit option must be chosen at the time of purchase and the benefit amount will be based on whether the payout already had begun. You can designate your spouse, children, grandchildren or anyone else to receive your QLAC funds. If you die prior to receiving any income payments, the amount you paid into the QLAC is paid to your beneficiary. Talk to your financial adviser, tax professional and/or estate attorney about what it would mean for your beneficiaries.

See Also: Understanding Inherited IRAs and Their Inherent Dangers

A QLAC isn’t a magic bullet. It’s a fixed annuity, and you cannot change your mind once you have made the deposit. You need to be certain that this is money that you do not need nor want to pay tax on prior to the date the income begins.

One important provision that you can include in your QLAC to protect yourself is an income start date change rider. This will commonly allow you to accelerate the payment of income to as short as five years after you made the purchase if you decide you need additional income. You’re forfeiting liquidity of your money that is deposited into the QLAC in return for being able to reduce the amount of your RMD to a maximum of your age 85.

See Also: Leave Your Loved Ones a Generous Legacy — Not a Tax Bill

Kim Franke-Folstad contributed to this article.

Carl W. Zeidler is the founder of Wall Street Financial Group Inc. and the director of financial planning and investment services. He is an insurance professional and an Investment Adviser Representative through Wall Street Financial Group. Wall Street Financial Group is a Registered Investment Adviser in Illinois, Missouri and Tennessee.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.