People may be concerned about outliving their retirement income as they live longer these days. This is true especially since tax law requires them to begin taking mandatory distributions from their retirement plans (such as IRAs) once they reach age 70.5. These distributions, called required minimum distributions (RMD), are generally determined by dividing the retirement account balance at the end of the preceding year by the individual’s life expectancy from an IRS annuity table. While most retirees need the money from these distributions to live on, some individuals may still be working or have other resources, and they may not want or need to withdraw funds from their retirement accounts at this time. Unfortunately, it isn’t as easy as just not taking some or all of the required distribution because, when less than the RMD is taken, a stiff penalty is applied equal to 50% of the difference between the RMD that should have been withdrawn and the amount actually distributed for the year.
IRS regulations finalized in 2014 provide some relief for individuals who want to stretch out their retirement funds by allowing taxpayers to use up to $125,000 or 25% of their retirement account (whichever is lower) to purchase a qualified longevity annuity contract (QLAC) within the account. The amount used to purchase the QLAC is subtracted from the account balance, thus reducing the RMD from the retirement account each year until a specified time in the future when distributions from the annuity must begin.
Although this is not a perfect solution, a QLAC can, in effect, delay the distributions associated with the funds used to purchase the QLAC until as late as the predetermined date for the start of the annuity payments (no later than age 85).
As an example, Dan, who is age 72, has a traditional IRA with a balance of $700,000. From the IRS annuity table for age 72, Dan has an expected distribution period (life expectancy) of 25.6 years, and his RMD for the year would be $27,344 ($700,000/25.6). However, Dan could have purchased a QLAC in the amount of $125,000 (as this is less than 25% of $700,000) with IRA funds prior to the end of the year, thus reducing the IRA balance that is currently subject to mandatory distribution to $575,000. As a result, his RMD for the year would be $22,461. In addition, his QLAC would begin distributions at whatever date Dan selected for the start date (no later than age 85).
Since Social Security (SS) income becomes taxable when half of the taxpayer’s SS benefits plus the taxpayer’s other income (including nontaxable interest income) exceeds $25,000 ($32,000 for married taxpayers filing jointly), using a QLAC to reduce a taxpayer’s RMD income can actually reduce the tax on the taxpayer’s SS income.
QLACs do not apply to Roth IRAs, which have no RMD requirements and generally provide tax-free income.
Although many taxpayers are not fans of annuities, they do provide a guaranteed income for life and address the risk of outliving their assets while also delaying distributions to a later time for those who are still working or who have no current need for distributions. Please call Dagley & Co. if you have questions about how a QLAC might apply to your situation.
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