Learn about an annuity that can help reduce required minimum distributions (RMDs)
Defining a QLAC
Learn more about RMDs at our next no-cost webinar on tax planning for federal employees -
What is One of the Main Purposes of Investing in a QLAC?
How a QLAC May Work
The following example illustrates how a QLAC may work:
Example 2. Doris, age 65, is a federal annuitant who directly rolls over $200,000 from her traditional TSP to a traditional IRA. She then invests the $200,000 in a QLAC from an insurance company. Under the terms of the annuity contract, the annuity provider will pay Doris (starting at age 85) $134,000 annually. If Doris lives to age 100, she would have received a total of 15 years times $134,000 per year, or $2,010,000.
The $2 million plus from the QLAC that Doris will potentially receive sounds valuable to Doris. Note, however, that as a result of investing the $200,000 in the QLAC, Doris is forgoing investing the $200,000 had she kept the money in her TSP account or in her IRA. The tradeoff is the opportunity cost of not contributing the $200,000 to a QLAC to potentially grow in her IRA at a higher investment rate. Suppose she invested the $2000,000 in her traditional IRA in such a way to get an average 5 percent annualized investment return over 20 years. In that case, over 20 years from age 65 to age 85 the $200,000 would have grown to $530,660. Note that past investment returns are no guarantee of future investment performance.
The question: In Doris’ case, is buying a QLAC worth foregoing the potential appreciation of the $200,000 to $530,000? The answer is most probably yes because without investing the $200,000 in a QLAC, there would be traditional IRA RMDs starting when Doris becomes age 73. The RMDs will have an effect on the hypothetical 5 percent annualized investment return. In addition, federal and state income tax rates may be higher over the next 20 to 30 years, further diminishing Doris’ investment return.
Which Individuals are Prime Candidates for QLACs?
Those individuals who are taking their RMDs (TSP, traditional IRAs, or both) and who do not need their RMDs to support their lifestyle are prime candidates to use QLACs. The following example will illustrate:
Example 3. Dan, age 78, is a federal retiree, a CSRS annuitant whose CSRS annuity amount is currently $160,000 per year. He also has about $250,000 in the traditional TSP. Dan is married to Darlene, age 74, who has $710,000 in her traditional IRA. Dan is giving a full survivor annuity to Darlene. For the year 2023, Doris must take a traditional IRA RMD equal to $710,000/25.5 or $27,843. Dan and Darlene do not need the $27,843 to support their lifestyle.
Darlene is also committed to converting $100,000 in her traditional IRA to a Roth IRA each year for the next four years, which is taxed at a modest rate but will reduce her traditional IRA RMDs.
How a QLAC May Work
Darlene’s QLAC purchase and Roth IRA conversions are part of a “trifecta” that can generate current and future tax savings for high-net-worth individuals who do not need their RMDs to support their lifestyle. The third component is the use of qualified charitable distributions (QCDs) in which traditional IRA owners aged 70.5 and older can further reduce traditional IRA RMDs. The following is how Dan’s and Darlene’s “trifecta” plan will play out over the next few years.
Year 1. Darlene will use $200,000 of her traditional IRA to purchase a QLAC, with payments starting at age 85, and continue if Darlene were to predecease Dan. The $200,000 will not be included in the calculation of Darlene’s traditional IRA RMD starting in year 2. Darlene will also convert $100,000 of her traditional IRA to a Roth IRA. This conversion will increase Dan’s and Darlene’s tax bill in year 1 but will reduce Darlene’s future year traditional IRA RMDs.
Year 2. Darlene will make $27,500 of QCDs from her traditional IRA to her favorite charities in order to satisfy her year 2 traditional IRA RMD without creating any tax liability. She also plans to convert another $100,000 of traditional IRA to a Roth IRA which will generate a tax bill but will reduce future traditional IRA RMDs.
Year 3. Darlene will make $27,500 of QCDS and thereby satisfying her traditional IRA RMDs. She will convert another $100,000 of her traditional IRA to a Roth IRA.
Going forward, Darlene’s traditional IRA balance will soon be below $200,000. Her traditional IRA RMDs will be modest and covered by her making QCDs. Starting in 2034 when Darlene becomes age 85, under the terms of her QLAC, the QLAC provider will pay her annually $48,644. The $48,644 (fully taxable) each year can be offset by using QCDs.
If Darlene were to predecease Dan, then he would be eligible to receive: (1) Lifetime income of $48,644 annually from the QLAC; and (2) a Roth IRA inherited from Darlene which he can rollover into his own Roth IRA, with no RMDs.
Because the use of a QLAC, Roth IRA conversions and QCDs can reduce RMDs and therefore adjusted gross income (AGI), Medicare Part B and Medicare Part D monthly premiums (which are dependent on a Medicare Part B and Medicare Part D enrollee’s AGI) can also be reduced.
A QLAC can be a valuable tool for federal retirees to reduce their TSP and traditional IRA RMDs, thereby resulting in reduced future taxable income and federal and state tax liabilities, and Medicare Part B and Medicare Part B monthly premiums. Federal retirees who are interested in investing in a QLAC are encouraged to speak with their financial advisor in order to determine if investing in a QLAC is suitable for them and will help them achieve their financial goals.
*The investment profiles above are hypothetical, and the asset allocations are presented only as examples and are not intended as investment advice. Please consult with your financial advisor if you have questions about these examples and how they relate to your own financial situation.
A fixed annuity is a long-term, tax-deferred insurance contract designed for retirement. It allows you to create a fixed stream of income through a process called annuitization and also provides a fixed rate of return based on the terms of the contract. Fixed annuities have limitations. If you decide to take your money out early, you may face fees called surrender charges. Plus, if you're not yet 59½, you may also have to pay an additional 10% tax penalty on top of ordinary income taxes. You should also know that a fixed annuity contains guarantees and protections that are subject to the issuing insurance company's ability to pay for them.
Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.