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The Annuity with a Tax-Planning Twist

Retirees sometimes feel like they’re being squeezed by two opposing goals, says David Rodeck, Kiplinger’s Personal Finance.

On the one hand, they should conserve their nest egg to prepare for longer life expectancies and the rising cost of long-term care. On the other, the IRS requires retirees to start drawing down their savings with required minimum distributions at age 72. A qualified longevity annuity contract (QLAC) satisfies both goals, explains Rodeck.

QLACs are a type of deferred income annuity that can guarantee you payments for life. You transfer a portion of your savings from a retirement account, like an IRA or a 401(k), to an annuity company to purchase your contract. As of 2020, you can invest the lesser of $135,000 or 25% of your retirement account balance in a QLAC. The annuity company turns your deposit into payments, which you can delay taking until as late as age 85. (Once you start receiving payments, the income will be subject to regular income tax.)

Although QLACs have been on the scene since 2014, they are hardly a household name. But legislation in 2019 and a rising tide of baby boomers entering their 70s could launch these contracts out of obscurity and into the retirement planning spotlight.

Besides generating lifetime income, QLACs can also help reduce required minimum distributions. When you turn 72, you must draw down your retirement accounts, even if you don’t need the money. While you could reinvest your RMDs and keep saving, this goes against human nature, says Steven Kaye, managing director at Wealth Enhancement Group in Warren, N.J. “When money comes out of a retirement plan, people tend to spend it. This increases the chance they outlive their nest egg,” he says.

With a QLAC, the portion of savings used for the annuity is excluded from the calculation to determine RMDs. For example, if you have $500,000 in an IRA and transfer $100,000 into a QLAC, your RMD is based only on the remaining $400,000.

RMDs “can push you into a higher bracket, which increases taxes on investments and other income,” says Steve Parrish, co-director of the Center for Retirement Income at the American College of Financial Services. He sees QLACs as a valuable tool for retirees.

Your payout from a QLAC depends on the age when you start collecting income (the later you start, the higher the payment), your gender (women receive less per year because of their higher life expectancy), and whether you set the lifetime payments on one life or two, such as for you and a spouse (a joint life annuity pays less per year).

A free calculator (digital.fidelity.com/prgw/digital/gie/) from Fidelity demonstrates the potential return.

The return can be impressive if you live long but looks mediocre if you die early, especially if it’s before receiving payments. Setting up the contract with a return of premium rider guarantees that your heirs receive at least as much as you paid into the contract. If you bought a contract for $135,000 and died before receiving payments, your heirs would get $135,000.

Editor’s Note: David Rodeck is a contributing writer to Kiplinger’s Personal Finance magazine, www.Kiplinger.com.

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