Exchange Options Boost the QLAC Appeal Post-SECURE

by Prof. Robert Bloink and Prof. William H. Byrnes

Qualified longevity annuity contracts (QLACs) are rarely placed in the spotlight when it comes time to evaluate retirement income planning solutions.  Generally, QLACs are subject to tight restrictions that can make them unattractive to taxpayers who may not want to risk waiting until age 85 to access their hard-earned retirement dollars.  In recent years, legislators have used the pair of SECURE Acts to increase the appeal of the QLAC structure by increasing the flexibility of the rules governing these annuities.  The most recent IRS guidance has built upon this flexibility and now offers a degree of peace of mind for clients who have feared being locked into an annuity contract that later turns out to be a wrong fit.  QLAC exchanges are now on the table, and advisors should brush up on the new rules to guide clients who may now take a stronger interest in the benefits of QLACs.

QLACs: The Basics

QLACs are deferred annuities purchased with retirement plan dollars.  Annuity payments are deferred until the client reaches a certain age to provide retirement income security late in life (payments must generally begin no later than the month following the month when the client reaches age 85, although they can begin earlier).

From an income tax perspective, QLACs are beneficial in that the value of the QLAC is excluded when the owner calculates RMDs.  This, of course, allows the owner to reduce ordinary income tax liability once RMDs kick in by reducing the overall account value used to calculate required annual distributions.

Under the original rules governing QLACs, taxpayers were limited to purchasing a QLAC with an annuity premium value equal to the lesser of (1) 25 percent of their account value or (2) $145,000 (as adjusted for inflation in 2022, prior to the SECURE Act 2.0 modifications).  The 25 percent limit was applied separately to separate employer plans, but in the aggregate when it came to IRAs.

Once QLAC payments begin, the amounts are subject to ordinary income tax just like any other traditional retirement account distribution.

The SECURE Act 2.0 eliminated the rule that previously limited the value of a QLAC to 25 percent of the account's value.  Further, the law modified the old rule that limited the value of the QLAC to $125,000 by raising the cap to $200,000 (as indexed for 2023 and 2024).

Taxpayers can also now benefit from a "free-look period" of up to 90 days, during which the taxpayer can rescind the purchase of the QLAC without penalty.

IRS Guidance on QLAC Exchanges

The IRS included guidance on QLAC exchanges in the RMD regulations issued earlier this year.  Those regulations essentially bless the exchange of one QLAC for another and provide details on the mechanics of the exchange.

First and foremost, taxpayers don’t have to exchange their QLAC to use the new, higher $200,000 contribution limit for premiums.  They can simply add to the existing QLAC, so long as the total premiums contributed do not exceed the $200,000 limit.

Taxpayers can, however, exchange an existing QLAC for a new QLAC (again, the total premiums paid cannot exceed the $200,000 limit).  The regulations provide that, for purposes of the limit on premiums used to purchase a qualified longevity annuity contract (QLAC), if another insurance contract is exchanged for a QLAC, the fair market value of the exchanged contract is treated as the premium paid for the QLAC.

The final regulations also provide that if an insurance contract is surrendered for its cash surrender value, the surrender extinguishes all benefits and other characteristics of the contract, and when the cash is used to purchase a QLAC, only the cash from the surrendered contract is treated as a premium paid for the QLAC.

The regulations also offer guidance on the consequences of a divorce on an existing QLAC. Payment of survivor benefits to an individual’s former spouse under the annuity does not cause the contract to fail to satisfy the QLAC requirements merely because their divorce occurred after the contract was purchased.  That's true if a QDRO satisfying certain requirements has been issued in connection with the divorce.

The QDRO must: (1) provide that the former spouse is entitled to the survivor benefits under the contract; (2) provide that the former spouse is treated as a surviving spouse for purposes of the contract; (3) not modify the treatment of the former spouse as the beneficiary under the contract who is entitled to the survivor benefits; or (4) not modify the treatment of the former spouse as the measuring life for the survivor benefits under the contract.

The regulations related to QLACs were effective as of September 17, 2024.

Conclusion

With the recent changes that apply to QLACs, many clients should be advised to reevaluate the option, considering, of course, their unique financial situation, retirement security goals and overall health.

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