Tax Strategy: Longevity Annuity Rules
The final IRS longevity annuity regulations -- designed to help promote the use of qualified longevity annuity contracts with retirement accounts -- create an important option for retirees with 401(k), 403(b), 457(b) or IRA accounts to help ensure that they will not run out of retirement funds before they die through the use of qualified longevity annuity contracts.
Advisors will want to discuss this option with their clients, weighing the costs against the benefits and against other possible alternatives. Employers will also want to weigh the merits of adding this feature to their defined-contribution plans.
The final regulations follow fairly closely proposed regulations that were issued in 2012, with a number of enhancements added in response to comments submitted on the proposed rules. These new regulations apply to annuity contracts purchased on or after July 2, 2014.
Several requirements must be satisfied to qualify as a QLAC under the final regulations:
1. The required premium must not exceed the lesser of $125,000 or 25% of the individual's account balance;
2. The annuity contract must provide that payouts begin no later than the first day of the month following the purchaser's 85th birthday;
3. The contract cannot be a variable, indexed or similar contract, and may not provide for any commutation benefit, cash surrender right or other similar feature except as specifically authorized by the IRS;
4. The contract may include a return-of-premium feature and a surviving spouse annuity or may provide for a reduced annuity to a non-spouse beneficiary as provided in the final regulations; and,
5. The contract must state that it is intended to be a QLAC, with provisions provided in the final regulations for modifying existing annuity contracts.
The final regulations provide that the value of QLACs may be excluded in determining valuations for required minimum distribution purposes. An annuity is a QLAC only if it meets the requirements of the final regulations. Prior to the final regulations, the RMD rules would have forced taxpayers to factor the premium amounts into the calculation of their annual distribution, depleting the account funds more quickly than the actual balance, without the premium payment, would have warranted. Under the final regulations, the required minimum distribution may be based on the full remaining account balance without regard to the fact that a portion was paid as a premium for a QLAC.
The total value of all QLACs held by one person cannot exceed the lesser of $125,000 or 25% of the total of all qualified retirement accounts held by the person. The $125,000 sum is adjusted for inflation in $10,000 increments. IRA accounts are aggregated for the percentage limits, but employer plans are considered separately. For the dollar limits, IRAs and employer plans are all aggregated together. Roth IRAs are not included.
The 25% limit is applied to the account balance under a qualified plan as of the last valuation date preceding the date of a premium payments, increased for contributions allocated to the account and decreased for distributions made from the account between the valuation date and before the premium is paid.
A correction method is provided in the event that a premium is paid that exceeds these limits - the excess premium must be returned to the non-QLAC portion of the account by the end of the calendar year following the year in which the excess premium is paid. The excess premium can be returned in cash or treated as a premium for a non-QLAC annuity. If the correction is not timely made, the annuity contract will be treated as a non-QLAC annuity beginning on the date of the first premium payment under the contract.
ANNUITY START DATE
The final regulations specify that the annuity starting date must be no later than the first day of the month following the annuitant's attainment of age 85. The IRS is given discretion to adjust this age as changes in mortality estimates occur. The retiree may select an earlier age to start the annuity.
The final regulations permit a return-of-premium feature. A return of premium is an annuity contract that, if the annuitant dies before receiving payments at least equal to the premium paid under the contract, an additional payment will be paid to bring the total payments at least equal to the premium paid. The return-of-premium feature may apply either before or after the annuity starting date. While a return-of-premium feature may make longevity annuity contracts more appealing to some individuals, they add considerably to the cost of the contracts. The regulations permit the return of premium to be in the form of a lump-sum payment or a survivor life annuity payable on the annuitant's death. A surviving spouse receiving an annuity may also have a return-of-premium feature. A non-spouse beneficiary may also receive a reduced annuity based on tables in the final regulations, but a non-spousal beneficiary would not receive an annuity if there is a return-of-premium feature.
A QLAC may provide for an inflation-adjusted annuity, if permitted by the plan documents. However, a QLAC may not be a variable or indexed contract, such as a contract tied to the movement of a basket of equities. QLACS must not provide any commutation benefit, cash surrender right or similar feature; however, the IRS is authorized to create exceptions.
QLAC issuers are required to submit annual reports to the IRS and the annuitant updating the status of the annuity contract. These reports must begin in the year in which the premiums are first paid and continue until the earlier of the year in which the participant (and the participant's spouse, if applicable) reaches the annuity starting age or dies. Participants will be required to provide the plan administrator with annual valuations.
Many commentators have expressed concern about how widely longevity annuity contracts will be utilized. From the annuitant's perspective, annuities involve parting with cash now in exchange for payments in the future of uncertain duration. The deferred start of payments with longevity annuities adds even greater uncertainty. Recent studies indicate that longevity annuities only represent about 1% of the market, and even immediate annuities are often a tough sell. The addition of a return-of-premium feature may alleviate some of these concerns, but it also comes at a cost of either higher premiums or lower monthly payments.
The projected return on longevity annuities has not looked especially attractive compared to possible alternatives available to a retiree, such as investing the money that would be used for the premium payment or electing to defer Social Security. However, the final regulations may encourage more insurance companies to enter the longevity annuity market, perhaps improving returns due to competitive pressures. Rising interest rates may also result in improved returns on longevity annuities.
From the employer or plan administrator's point of view, there may be concern about possible fiduciary liability if the annuity company selected does not fulfill its commitments. There may also be administrative concerns about being locked into a particular QLAC provider for such a long period of time. Employers deciding to offer QLACs will have to decide whether to offer them on an elective or mandatory basis and evaluate any necessary plan amendments.
If there are existing annuity contracts as of July 2, 2014, the final regulations permit them to be exchanged for an annuity that meets the requirements of a QLAC. The QLAC will be treated as purchased on the date of the exchange. The fair market value of the contract will be a premium that counts toward the QLAC limit.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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