5 Key QLAC Rules to Help You Defer Taxable Income

financial freedomMy Comments: Yesterday, President’s Day, was all about memories and things past. Today, we’re back with a somewhat esoteric idea to help you grow and keep your money.

Much of the talk in Washington these days is about income inequality and how much the 1% make each year. For some of us in the 99%, there is little dispute that legitimate ways can be found that defer taxes. This is one of them.

The IRS recently approved a way for us to defer ordinary income taxes on some of the money we may now have in what are known as “qualified plans”. That’s IRS speak for money that has NOT BEEN TAXED YET. Think IRA, or 401k, or 403b, and so on.

They, the IRS, introduced QLACs, which is an acronym for Qualifed Longevity Annuity Contracts. Here is a definitive explanation. (BTW, I have no idea what the initials after the authors name implies!)

Denise Appleby, APA, CISP, CRC, CRPS, CRSP

A longer life expectancy is one of the many benefits of modern medicine and healthy living. But with that longer life comes the risk that retirees may outlive their savings – a primary concern for many Americans.

To address those fears, many financial advisors are recommending annuity products, and the IRS has joined in by issuing final regulations on qualified longevity annuities that individuals can purchase in eligible retirement accounts. These regulations, issued on July 21, 2014, apply to contracts purchased on or after July 2, 2014.

With the exception of Roth IRAs, retirement account owners must begin to take required minimum distributions (RMDs) for the year in which they reach age 70½. Qualified plans, 403(b)s and governmental 457(b) accounts can allow eligible participants to defer starting RMDs past age 70½ until retirement.

An RMD amount for a year is calculated by dividing the previous year-end fair market value (FMV) of the retirement account(s) by the account owner’s applicable life expectancy for the RMD year.

If an individual owns multiple traditional, SEP, and SIMPLE IRAs, the RMDs for each of those IRAs must be calculated separately, but can be totaled and taken from one or more of the IRAs. This aggregation treatment can also be applied if an individual owns multiple 403(b) accounts.

RMDs cannot be aggregated for qualified plans, such as 401(k) and pension plans.
Some individuals who already have sufficient income from other sources may prefer to avoid or defer the usually taxable income from RMDs for as long as possible. The qualifying longevity annuity contract (QLAC) rules provide what some consider a partial solution for these individuals.

The following is an explanation of some of the key QLAC provisions.

1. Eligible accounts
These QLAC rules apply to traditional IRAs, defined contribution plans, 403(b) plans, and eligible governmental 457(b) plans. For this purpose, “traditional IRA” includes SEP IRAs and SIMPLE IRAs. These QLAC rules do not apply to Roth IRAs because the RMD rules do not apply to Roth IRA owners. They also do not apply to defined benefit plans, as defined benefit plans already provide for distributions in the form of annuities.

2. Delayed required beginning date provides opportunity for deferred RMD income
Generally, RMDs must begin by the required beginning date (RMD), which is April 1 of the year that follows the year in which the account owner reaches age 70½.

For employer-sponsored retirement plans, the required beginning date (RBD) can be deferred until April 1 of the year that follows the year in which the participant retires from working for the plan sponsor. For retirement account owners who would prefer to defer starting RMDs past the RBD, QLACs provide an opportunity to defer RMDs on a portion of their account balances.

Under the QLAC rules, the annuity starting date for a QLAC is the first day of the month following the month in which the retirement account owner reaches age 85. A QLAC could include provisions that allow an earlier start date, but it is not required to do so.

3. QLAC excluded from FMV in RMD calculation
The value of a QLAC is excluded from the FMV used to calculate RMDs for the years before the annuity start date. This allows for a smaller RMD amount for those years.

4. QLAC Limits
The amount of the premiums paid for a QLAC cannot exceed the lesser of $125,000 or 25% of the owner’s account balance on the date of payment.

The $125,000 limit rules
• All of the owner’s retirement accounts are aggregated for the purpose of the $125,000 limit.
• The $125,000 is reduced by any QLAC premiums paid on or before the date of the QLAC premium payment for any other IRA or employer-sponsored retirement plan.
• The $125,000 limit is indexed for inflation in $10,000 increments.

The 25% limit rules
• The limit is determined separately for each defined contribution plan.
• The limit is determined separately for each eligible governmental 457(b) plan.
• The limit is determined separately for each 403(b) plan. This is a deviation from the RMD rules, which provide that 403(b) accounts can be aggregated for RMD purposes (see background section above).
• IRA balances are aggregated and treated as one when determining if this limit applies. Consistent with the RMD aggregation rule for IRAs, a QLAC can be purchased in one IRA even if another IRA balance is used to satisfy the 25% limit.
• The 25% is reduced by any QLAC premium payment for the same QLAC or another QLAC that is held or purchased for the owner’s IRAs.
• Aggregation by account type is not allowed. For instance, IRAs cannot be aggregated with qualified plans or 401(k) plans.
• IRA balances are determined as of Dec. 31 of the year that precedes the year in which the premium is paid.
• For employer-sponsored retirement plans, the balance is the account balance as of the last valuation date preceding the date of the premium payment. This is adjusted by adding contributions allocated to the account during the period that begins after the valuation date and ends before the date the premium is paid and reduced by any distributions made from the account during that period.

An important distinction for the FMV is that while the QLAC is excluded for the purposes of calculating RMDs, it is included for purposes of applying the 25% limit.

Let’s look at some examples:
Example 1
Sally has a 401(k) account with a balance of $500,000, an IRA with a balance of $40,000, and a 403(b) with a balance of $25,000. If she pays a QLAC premium of $125,000 from the 401(k) account, no additional QLAC premiums can be paid from any of the other accounts. This is because her QLAC premiums cannot exceed $125,000.

Example 2
Assume that the facts are the same as in Example 1, except that Sally pays a QLAC premium of $25,000 from the 401(k) account. She can pay additional QLAC premiums from the other accounts as long as the aggregate payment does not exceed $125,000 and the premium from one account does not exceed 25% of the account balance.

Example 3
Jim has a traditional IRA with a balance of $50,000, a 403(b) account with a balance of $100,000, and a 401(k) with a balance of $200,000. Jim’s QLAC premium cannot exceed the lesser of $125,000 or 25% of his account balance.

Jim’s total account balance is $350,000 and 25% of that is $87,500. Because of the restriction on aggregation of the 25% rule, Jim’s QLAC premium cannot exceed:
• $12,500 for the IRA
• $25,000 for the 403(b) and
• $50,000 for the 401(k) account.
If all three of the accounts were IRAs, then the QLAC could have been purchased in any of the IRAs.

5. Roth LACs are not QLACs
Annuities, including qualifying longevity annuity contracts, are not QLACs if they are purchased in a Roth IRA, even if they otherwise meet all of the requirements for a QLAC. If a QLAC is converted to a Roth IRA, it loses its QLAC status as of the date on which the conversion occurs.

Amounts held in Roth IRAs, including any QLAC that is converted to a Roth IRA and, as a result, loses its QLAC status, are not taken into consideration when determining the $125,000 and 25% QLAC limits.

Responsibility for monitoring limits
In general, the account owner is responsible for ensuring that the QLAC limits are not exceeded. Unless the IRA custodian or plan administrator has knowledge to the contrary, they are allowed to rely on the account owner’s representation that the limits are not being exceeded. For qualified plans, the reliance on the account owner’s representation does not extend to amounts held under a plan that is not maintained by the employer.

If the premium amounts are exceeded, the annuity contract could fail to be a QLAC unless the excess premium is returned to the non-QLAC portion of the account on a timely basis.

Other factors to consider
The guaranteed lifetime income-deferred RMD on QLACs and reduced RMDs as a result of excluding QLAC premiums are only some of the factors that should be considered when determining suitability. Another issue to take into account is the benefits payable to beneficiaries, including any optional features available when choosing a QLAC product. The availability of optional features could vary among different providers and products.