The turn of the year is an ideal time to consider your tax strategy and retirement plan. It’s common for retirees to perform Roth IRA conversions and elect to delay taking Social Security distributions until age 70 in order to manage tax risk as well as bolster future income. Another popular method by which advisors can help clients achieve financial security is a Qualified Longevity Annuity Contract (QLAC) strategy.

What is a QLAC?

A QLAC is a type of deferred annuity that is bought with funds from a qualified retirement plan, commonly an IRA. Like most annuities, the contract owner pays a lump sum to an insurance company and in exchange receives a guaranteed future stream of income. With today’s higher interest rates and streamlined technology in the annuity space, it is perhaps easier and more cost-effective than ever to buy and own many types of annuities.

What’s unique about a QLAC is that the strategy safeguards assets from required minimum distributions (RMDs) for a set number of years. There are important limitations and qualifications to consider, however. Purchasing a QLAC is something many individuals and couples approaching and just starting retirement should consider if they wish to reduce RMD taxes and seek protection against outliving their assets. 

How Does a QLAC Work?

This relatively new type of tax-advantaged annuity contract allows individuals to take a portion of their retirement account assets and move them to an annuity that begins payouts to the policyholder at a deferred age, but no later than age 85. Income is then guaranteed for life. The current law for 2023 states that an individual can spend up to $155,000 or 25% of their retirement account savings (whichever is less) to purchase a QLAC. 

What makes a QLAC attractive is that it reduces pre-tax retirement savings account balances so that the RMD is reduced. Later in life, perhaps when taxable income is lower, the annuity begins payments to the policyholder. Moreover, being a deferred annuity, a QLAC provides significant longevity-risk mitigation.

What Makes a Deferred Annuity a QLAC?

Three important requirements must be met to call an annuity a QLAC. 

1. Money used to purchase the deferred annuity must be sourced from a pre-tax retirement account such as a Traditional IRA, Rollover IRA, 401(k), or 403(b) plan.
2. The most you can add to the contract in 2023 is $155,000 or 25% of your aggregate pre-tax retirement account balances (whichever is less). That dollar figure is an increase from $145,000 in 2022, and the limits in future years are indexed to inflation.
3. The individual must begin taking payments from the annuity no later than their 85th birthday. In general, the longer you delay receiving annuity income, the bigger your future monthly benefit will be.

Benefits of a QLAC

One of the biggest advantages of a QLAC is that it allows people to reduce their IRS-mandated RMDs. As the law stands, individuals must begin taking withdrawals from their qualified retirement accounts at age 72. While RMD amounts are often low on a percentage-of-assets basis early in retirement, required withdrawals generally increase with age, so having the flexibility to manage taxes is critical. Lower RMDs in your 70s can allow for strategic Roth conversions now before tax rates increase in 2026.

Another benefit of a QLAC is that it permits a spouse or nonspouse to be a joint holder of the account. Both annuitants can be covered by the policy, but the trade-off is that with any added policy features or riders the payout amount will be impacted. Another popular add-onr to a QLAC is a cost of living adjustment (COLA) that increases annuity payments with the rate of inflation.

In addition to the security a lifetime income stream brings to retirees, a QLAC removes market risk. Let’s say you want to buy an annuity from a pre-tax retirement account with assets of $1 million. With the 2023 limit of $155,000, you are capped at that amount. You can sell part of your stock or bond position to fund a QLAC purchase. By adding an income stream to your asset allocation and removing some stock and bond positions, you have diversified your risk and reduced some market exposure.

What’s more, a QLAC can be an effective retirement planning and tax savings tool for most investors. Given the dollar and percentage limits, it is effectively designed to help individuals and couples who have moderate, but not extravagant, pre-tax savings. Lower taxable income in retirement helps avoid being disqualified from other programs or getting slapped with an IRMAA surcharge.

Risks and Planning Strategies

As with any annuity, by purchasing a guaranteed future income stream with a lump sum, you give up liquidity and access to that capital. That is why retirees and those interested in purchasing an annuity should work with a financial planner to determine if such a policy makes sense. It’s also important to know that QLACs, like all annuities, are not FDIC-insured. In addition, there is no cash-value feature like there is with many insurance products.

To reduce concentration risk, individuals can purchase annuities from a few different insurance companies. This laddering approach spreads out the risk of fluctuations in market interest rates which can impact future payout amounts. For example, someone aged 65 might look to purchase $50,000 in QLACs annually for the next three years, each from a different annuity company. 

Perhaps the biggest risk with a QLAC is that the annuitant passes away before reaching the age when payments would begin. Also, you should consider a QLAC with a refund option, which distributes unused assets to heirs if you wish to leave a legacy. 

The Bottom Line

QLACs can be an effective retirement planning tool to manage taxes later in life. Moreover, this distinctive feature allowed in the tax code is aimed at the masses, not the ultra wealthy. Individuals and couples who have significant pre-tax savings, who are also concerned about outliving their money and wish to reduce RMDs, should consider working with an advisor to add a QLAC to their retirement portfolios.