Michael Finke, PhD, CFP, professor and director of retirement planning and living in the personal financial-planning department at Texas Tech University, Lubbock.
Do you think you’ll live past 85? If so, there’s a surprisingly attractive type of investment you can make now that starts paying off big once you reach that age—and never stops as long as you live. And thanks to a new twist, you can easily dip into your retirement accounts to fund it.
Don’t be scared off by its name. It’s called a Qualified Longevity Annuity Contract, or QLAC for short. And don’t be frightened by the fact that it’s an annuity—even though there are many types of annuities that have bad reputations and should be shunned.
Unlike many of those annuities, which can be extraordinarily complex and charge exorbitant annual fees, QLACs are easy to understand and have no annual fees. And your payout amount is fixed and guaranteed, unlike with some annuities that are linked to the performance of stocks.
For many people, a QLAC is the best way to guarantee that they won’t run out of money if they live past age 85. And it has big tax advantages (see below).
How a QLAC typically works: You hand over a lump sum of money, which can come from a taxable account or a retirement account such as a traditional IRA or 401(k), to an insurance company that provides the annuity. You don’t get anything back at first. But once you turn 85, the insurer starts paying you a guaranteed fixed monthly amount. This amount will depend on your age when you purchased the annuity, how much money you paid, your gender (women will receive a lower monthly amount than men because they tend to live longer) and how high interest rates were when you bought the QLAC.
The payments typically are a lot bigger than what you could earn from a long-term bond portfolio that you might invest in on your own.
Why are QLACs such a big opportunity now? In the past, there was a serious drawback to longevity annuities for people who had most of their money tucked away in retirement accounts. That was because upon turning age 70½, all investors in traditional IRAs, 401(k)s and some other accounts are required to begin taking required minimum distributions (RMDs) from those accounts—but if a big chunk of the money in those accounts was tied up in a longevity annuity, these people might not be able to withdraw enough to meet the RMD requirement. The result would be substantial penalties.
New solution: Two years ago, the IRS approved a twist on the longevity annuity and called it a QLAC, which too many investors still are not taking advantage of. With this type of longevity annuity, you don’t have to start meeting RMD requirements from the portion of the account devoted to the QLAC until age 85, when you will start receiving payouts from the annuity. Even better, the payouts themselves are deemed to fulfill the RMD requirements for the invested amount. (Some investors buy QLACs that start paying out at a younger age, but that is uncommon because it diminishes the size of the payouts and the advantage of delaying RMDs.) Only a limited amount of money can be used to buy QLACs—a total up to 25% of the value of all your retirement accounts or up to $125,000, whichever is less.
Because you are not taking RMDs for all those years between age 70½ and 85, you are not paying taxes on those RMDs. You also benefit from what insurance companies call “mortality pooling,” which means that the monthly payout amount that the QLAC offers reflects, in part, the money that the insurer won’t have to pay out to QLAC holders who die before age 85.
Example of how much a QLAC might pay out: A 65-year-old man who buys a $125,000 QLAC today can expect to receive about $60,000 in income each year starting at age 85 and then as long as he lives. In comparison, if he invested in a portfolio of 20-year AAA-rated corporate bonds at age 65 and wanted to re-create the same payouts from age 85 to 100, he would have to start out with a $304,000 investment, not $125,000 (thus costing $179,000 more), assuming a 4% interest rate. Since women live longer, a 65-year-old woman who pays $125,000 for a QLAC today would get $50,000 of annual income.
The many advantages don’t mean that QLACs are perfect for everyone. They probably won’t work for you if one or more of the following applies…
Important: Even if you will have plenty of income from such sources as pensions and Social Security, be sure not to invest so much in a QLAC that you are not able to also maintain a sufficient emergency cash fund.
Ways to get the most out of a QLAC…
Buy only from a major, highly rated insurance company. Check quotes for QLACs from various insurers at ImmediateAnnuities.com. Check that insurers’ credit ratings are A+ or better at AMBest.com or StandardAndPoors.com. However, if an insurer runs into financial problems and is unable to meet its QLAC payouts, each state has an insurance guarantee fund that takes over the obligation but is subject to coverage limitations. Example: Florida pays out a maximum of $300,000.
Calculate how much a QLAC will cost and end up paying out based on a purchase at different ages. You can do this at ImmediateAnnuities.com for various annuity providers. The younger you are, the cheaper it is to get a QLAC that offers a certain level of income starting at age 85. Example: If a 65-year-old man wants guaranteed income of about $35,000 a year, he must pay about $70,000 for a QLAC now. A 70-year-old man would have to pay $82,750 to obtain the same income.
Because it is likely that long-term rates will rise, it may make sense to spread QLAC purchases over several years, perhaps buying one per year over four years. That’s because higher rates when you buy a QLAC mean higher payouts.
Consider adding riders to your QLAC, but keep in mind that riders will reduce your eventual payouts. Common riders…
Cost-of-living-adjustment (COLA) rider: This adjusts payouts starting in the second year. The rider generally pays for itself within five to eight years after payouts begin, depending on how high inflation is.
Return-of-premium rider: With this, your spouse and other heirs receive the initial amount you invested in the QLAC if you die before you get any payouts. For couples, I often suggest that both spouses get a QLAC, if they can afford to, likely making this rider unnecessary. Costs vary widely.