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Small Business Financial Article

Small Business Financial Article
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

Using a QLAC to Stretch Your RMDs and Protect Against Longevity

Using a QLAC to Stretch Your RMDs and Protect Against Longevity

Business owners getting ready to retire must confront the unprecedented challenge of providing for their own lifetime income sufficiency in the face of expanding life spans. There is enough to be concerned with just making sure they have enough money to last 30-plus years. However, along the way, they must also contend with required minimum distributions (RMDs), which can have the effect of draining their retirement assets more quickly than is safe for longevity purposes. That is why an increasing number of retirees are turning to qualified longevity annuity contracts (QLACs) to reduce their RMDs and ensure their lifetime income sufficiency.

The Problem with RMDs

The tax code allows you to defer taxes on your qualified retirement plans until you start taking withdrawals when you retire. As the term “defer” implies, the government intends to collect taxes on your retirement income at some point. To ensure that taxes can’t be deferred forever, it came up with the RMD provision. While it seems reasonable enough on its face, the RMD rule includes a very nasty penalty if it is not followed to the letter. Starting at age 70 1/2, if you fail to withdraw the proper amount, you will be charged a 50 percent penalty on the amount not withdrawn.

The problem for some retirees is the RMD, which is calculated by dividing their qualified plan balance by the remaining years in their distribution period, may be more income than they need. While they can reinvest their excess income from an RMD, they lose a portion of their future income in current taxes. Until recently, there was really no way around this.

How a QLAC Works

QLACs, also referred to as “longevity insurance,” were created for the specific purpose of addressing the risk of longevity – outliving your income. As with a traditional income annuity – or immediate annuity – a QLAC provides a guaranteed lifetime income in exchange for a capital investment, except that, instead of paying the income out currently, it is deferred for a period of time, usually about 20 years but no later than age 85. Until recently, QLACs could only be purchased outside of a qualified retirement plan. That solved one part of the problem – ensuring sufficient lifetime income – but, the RMD problem remained. It was still possible to drain your retirement assets too quickly and, because an investment in a QLAC is irrevocable, it created the potential for a liquidity squeeze if the retirement assets were depleted before the QLAC income kicks in.

That part of the problem was solved recently when the government decided to allow QLACs to be purchased inside a qualified retirement plan. Under this new provision, when a QLAC is purchased using retirement funds, the year-end balance is reduced by the amount invested in the QLAC. The provision limits the amount that can be invested in a qualified plan to 25 percent of the plan’s balance or $125,000, whichever is less. This would then lower your future RMDs by an equivalent amount. The $125,000 cap may be adjusted for inflation.

For example, if, at age 74, you had 23.8 years remaining for distributions (based on the life-expectancy factor in the IRS’s Uniform Lifetime Table), and your IRA balance at the end of 2017 was $400,000, your RMD for 2017 would be $16,807. However, if you used $100,000 of your IRA balance to purchase a QLAC, your fund balance for the purpose of calculating your RMD would be $300,000. That would reduce your RMD to $12,605.That reduction of more than $4,000 would continue throughout your life and, when you turn 85, the QLAC will start making guaranteed income payments.* In effect, by purchasing a QLAC inside your retirement account, you are able to defer a portion of your RMDs until age 85.

Planning Considerations for a QLAC

Although QLACs do not have cash surrender value – once your money is invested, it cannot be accessed except through future income payments – it can be purchased with a single-sum death benefit in an amount equal to the excess of premium payment paid. You can also purchase a return-of-premium option that can be paid before or after the annuity start date.

Planning for and protecting against longevity is fraught with uncertainty and the RMD rule doesn’t make it any easier for retirees. Having the ability to reduce your RMD by as much as 25 percent can make a difference for many retirees. However, that should not be your only consideration when purchasing a QLAC. While a QLAC is a way to ensure you have a guaranteed lifetime income stream, it may not be suitable in all situations. Planning with a QLAC can be complicated, which is why it is important to seek guidance from a retirement planning specialist.

*Distributions from a QLAC must start no later than the first day of the month following annuitization, which can be no later than age 85.

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