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Opinion: Here's how to create a pension and save on taxes

MarketWatch logo MarketWatch 10/10/2019 Howard Gold

Lots of people would like to create their own pension but don’t have the cash in their nonretirement accounts to buy an annuity, which often requires a large lump-sum premium to provide a substantial monthly payout later on.

That’s where qualified longevity annuity contracts (QLACs) come in. They let you tap into your tax-deferred retirement accounts, where people usually have most of their savings, to make that initial premium payment. And they allow you to shelter that money from taxes until you start getting your monthly payouts, usually in your 80s. Call it two benefits for the price of one.

QLACs are fairly new products—in 2014 the Internal Revenue Service approved their purchase with pretax money from retirement accounts—but they haven’t exactly taken off. Last year all deferred income annuities, of which QLACs are one type, accounted for $2.3 billion in sales, a mere 1% of total annuity sales, according to Limra. That’s partly because people are reluctant to shell out money now for a payoff later and also because QLACs are sold by insurers while people’s retirement money is managed by investment companies.

But fund companies like Fidelity are making it easier to buy QLACs and more insurers are getting into the market. Also, the Secure Act, which passed the House of Representatives by 417-3 but is awaiting a vote in the Senate, will make it easier for employers to offer annuities in defined-contribution plans like 401(k) accounts.

Anyone who has an IRA or 401(k) can open a QLAC, but there are limits on how much you can put in—the lesser of $130,000 or 25% of your non-Roth retirement assets as of Dec. 31 of the previous year. You pay that money to an insurance company to buy a deferred annuity that starts paying out any time up to age 85, when you must start getting your payments. You cannot use a QLAC to buy variable or indexed annuities.

You can buy a QLAC any time, but most people get them before they turn 70½, which is when the IRS requires you to start taking required minimum distributions (RMDs) from your IRAs and 401(k) plans.

“Really it’s into your 60s heading up to the 70s that is kind of the sweet spot,” said Joe Signorella, founder of QLACQuote.com, an independent annuity agency based in Oak Brook, Ill.

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When you buy a QLAC, you subtract the amount you contribute from the total retirement assets that are used to calculate your RMDs, so you’ll defer taxes on the amount you invest in the QLAC until you start taking payouts. Meanwhile you’re guaranteeing a pension-like income stream later in life, reducing the risk you’ll have to withdraw money during a bear market and the bigger risk you’ll run out of money entirely.

Let’s say you turn 70 this year and you had $600,000 in total retirement assets as of last Dec. 31. Subtract the $70,000 in your Roth IRA and that leaves you with $530,000, enough to make the maximum QLAC purchase of $130,000. After you buy a QLAC, subtract the $130,000 and you’re left with $400,000 worth of non-Roth retirement assets at the end of 2019 to calculate your RMDs.

Still with me? Good. Based on IRS tables, your RMD for next year, when you turn 70½, will be slightly over $15,000, which will be taxed as ordinary income. (You would have been required to withdraw an additional $4,900 a year in RMDs had you not bought the QLAC.) Meanwhile, according to QLACQuote.com, you would earn up to $3,900 a month at age 85 on a lifetime income-only policy from an insurer rated A or above.

Signorella explains that certain provisions—such as cash refunds of deposit, return to your beneficiaries of your remaining principal at death, or inflation protection—will cut down your monthly payout. So will taking payouts earlier—say, at age 80, because there will be less time to accrue benefits. You also can buy QLACs jointly with your spouse or even set up a QLAC “ladder,” where payouts begin at different ages. Signorella calculates that a QLAC would pay you more than twice as much over time as keeping the money in fixed income investments.

“It’s very easy to accumulate all of your assets and get your nest egg. But it’s two to three times harder to tear that nest egg apart and make it reliable income because there’s an infinite time period,” Signorella explains. With a QLAC slated to kick in at 85, then during the years from 65 to 85, “I have a defined 20-year period that I need to get my income. So it’s more manageable.”

Income security late in life: Isn’t that what defines a good pension? That’s why you should consult your adviser and consider buying a QLAC—if nothing else, then for the additional peace of mind it could bring.

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