The Great Panic of 2008 has caused many people to change their approach to investing. Unfortunately, the lesson that most people should have learned, that volatility is good, is not what most investors learned. The comment I hear most often is that they don’t want to go through another downturn in the market. Insurance companies are eager to feed on this fear by offering investment products designed to protect the investor from volatility and provide a way to avoid the bad markets. They are happy to provide a meager return in exchange for taking on the risk that investors want to avoid.
The latest product insurance companies have come up with to address this fear is longevity insurance. Ironically this product has been around for a very long time under the name of a life annuity. You hand over an amount of money to an insurance company and they will provide a monthly income for as long as you live. The monthly amount is based on your age and the amount of money you provide upfront. The monthly income can be tied to one life or on both spouses joint life. There are other variations that can be built into the contract that will affect the payment but the end result is that payments will continue until death. That is the essence of longevity insurance.
This concept has become so popular that the IRS has recently released proposed regulations regarding the purchase of longevity contracts within retirement accounts. These contracts create a problem in a retirement account because of the required minimum distributions (RMD) that must begin once the owner reaches age 70 ½. RMDs generally increase each year because your life expectancy is shorter after each birthday. After the account owner reaches age 80 to 85 the annual amount has usually increased to the point that the typical monthly payment from a longevity contract is no longer high enough to satisfy the minimum. That is a problem because the monthly payments cannot be modified after they start.
The IRS refers to these contracts in an annuity as a qualified longevity annuity contract (QLAC). If you are considering this type of investment for your IRA, you need to understand the rules the IRS has proposed. Failure to follow these rules could subject you to annual penalties for failing to take the proper RMD.
The IRS is proposing that these contracts can only be purchased until the first day of the month following the owner’s 85th birthday. Contracts purchased before this date can defer payments until that date. The amount you can invest is also limited to the lesser of $100,000 or 25% of your retirement account assets. You may own more than one contract as long as the total invested does not exceed this limit per owner. All of your IRAs (Roth IRAs are not included) must be considered for the purpose of the 25% limitation. Account valuations will be based on the date the QLAC is purchased.
Retirement account owners that follow these rules will be allowed to exclude the value of the funds invested in the QLAC for purpose of taking their RMD. Your RMD will be based only on the retirement account values outside of the QLAC. This will eliminate the problem created from annually increasing RMDs.
The maximum amount is on a per person basis. Spouses that file joint tax returns are each allowed to invest up to $100,000 in a QLAC. The owner of the QLAC may name a beneficiary but the death benefit must be a life annuity to the designated beneficiary. No other form of death benefit is allowed.
Another important restriction is that the QLAC cannot be in the form of a variable annuity or an equity-indexed annuity. The contracts must also be irrevocable and therefore cannot have a cash surrender value. Proposed regulations also prohibit popular features such as return-of-premium guarantees, lump sum options or period certain terms. This exclusion applies regardless of whether the beneficiary is a spouse. Non-spouses can be named as beneficiaries but they will be restricted to the life annuity option. Estates, charities and non-see through trusts do not have life expectancies and therefore cannot be named as the beneficiary of a QLAC.
The restrictions placed on QLACs make them less than an ideal choice for guaranteeing a life income. However, for the investor who wants guarantees and has all of their investable funds held in retirement accounts, the QLAC offers an attractive option. The IRS is expecting the proposed regulations will be effective later this year. Once these regulations take effect, this will be another option for the person that is concerned about outliving their retirement funds.
- Owning a life annuity in a retirement account creates problems satisfying
annual RMDs because the amount usually increases each year.
- Proposed IRA regulations regarding life annuities provide a way to avoid the
RMD problem when the rules are followed.
- There are restrictions on the amount that can be put into a life annuity
in an IRA in order to qualify. Make sure you work with an adviser that is
knowledgeable of these rules to avoid serious problems.