Longevity Annuities

Deferred income annuities (DIAs) recently have become popular. New regulations from the U.S. Treasury Department may increase their appeal, opening the way for so-called “longevity” annuities inside IRAs and employer retirement plans.

Later rather than sooner

With a DIA, you pay an insurance company now in return for a predetermined amount of cash flow in the future.

            

Example 1:

Grace Palmer is age 55, planning to retire at 65. She buys an income annuity now for $100,000. Depending on the specific features Grace requests, if she starts to receive payments immediately, she might get around $400 a month ($4,800 a year) as long as she lives.

           

Instead, Grace agrees to wait until she retires at 65 to start payments. In return for giving up her money for 10 years, with no return, Grace might get lifelong annual payouts of $800 a month. (Exact amounts will depend on the contract terms and the annuity issuer.)

Even later

Certain DIAs are known as longevity annuities. They begin paying out late in life, so they appeal to people who are concerned about running short of money if they live into their late 80s or 90s or beyond.

            

Example 2: 

Instead of starting her DIA payouts at 65, Grace asks for them to begin at 75 or later. Such a delay could increase her payouts to $2,000 a month or more, as her remaining life expectancy would be limited. Grace enters into this arrangement to assure herself that she’ll have substantial cash flow if she lives until an advanced age.

Solving the distribution dilemma

Until recently, such longevity annuities were impractical for retirement accounts because required minimum distributions (RMDs) typically start after age 70½. Seniors would have to take RMDs on the annuity value even though no cash would be coming from the annuity.

            

Example 3: 

Suppose Henry Adams had bought a longevity annuity inside his IRA to begin payments at age 80. At age 70½, when Henry has $500,000 in his IRA, the annuity issuer values the contract at $100,000. Under prior rules, Henry would have had to take RMDs based on a $500,000 value even though he had only $400,000 currently available. Henry would have been required to withdraw (and pay tax on) a relatively large amount, even if he doesn’t need all the money he’ll withdraw.

This unfavorable tax treatment would continue, year after year, as long as Henry waited for his longevity annuity. Thus, longevity annuities were not attractive for retirement accounts and few people bought them in their IRA.

This situation is about to change. In July 2014, the Treasury Department issued final regulations on qualified longevity annuity contracts (QLACs). If annuities meet certain conditions, they will be considered QLACs. That way, the account value won’t count for RMD calculations.

Pros and cons

Some insurance companies are working on QLACs that are expected to appear in 2015. QLACs might appeal to seniors who are likely to live well beyond normal life expectancy and who are concerned about running short of money. In addition, individuals who would like to trim their RMDs and, thus, leave more to heirs, may consider buying QLACs. The regulations permit QLACs to have a return of premium feature, which would pay beneficiaries the amount invested yet not paid out in annuity payments by the time the annuity purchaser dies.

            

On the downside, QLACs will not be permitted to have any liquidity features for the buyer. If a taxpayer invests $100,000 in a QLAC, all she can get in return will be her annuity payments.

Rules for QLACs

·         No more than 25% of an individual’s total IRA money can be invested in qualified longevity contracts (QLACs).

·         For this purpose, SEP IRAs and SIMPLE IRAs are included. Roth IRAs don’t count because there is no reason to hold a QLAC in a Roth IRA, where the owner never has required minimum distributions. 

·         The 25% limit also applies to each employer plan.

·         Counting all QLACs in all plans, an investor cannot invest more than $125,000. That ceiling will increase with inflation.

·         QLAC payouts must begin no later than age 85, although they can begin earlier.