[authors: Eleanor Banister and James P. Cowles*]
401(k) participants face the risk of outliving retirement assets. However, earlier this month, the Internal Revenue Service and the Treasury Department issued final regulations that make it easier for 401(k) plans, individual retirement accounts and other retirement programs to invest in certain annuity contracts that could help mitigate this risk.
How will these regulations affect your 401(k) or IRA?
One strategy to mitigate the risk of outliving 401(k) account or individual retirement account (“IRA“) assets is to invest in annuity contracts that delay the commencement of benefits until after age 70 1/2. Annuities with a deferred commencement date (for example, benefits commencing at age 80 or 85) generally are less expensive than annuities commencing at an earlier age. However, prior to these final regulations, Internal Revenue Code rules required that the value of such annuity contracts be taken into account when determining minimum distributions that generally must begin after age 70 1/2. The final regulations make it easier to invest in deferred annuity contracts because certain of those contracts can be ignored when calculating the minimum amount that must be distributed from certain defined contribution retirement programs and traditional IRAs.
Under the new regulations, an employee may use a portion of his or her 401(k) account, IRA or other defined contribution retirement account to purchase a "Qualifying Longevity Annuity Contract" or "QLAC") on or after July 2, 2014. Payments made from a QLAC are not required to commence until the retiree reaches age 85 and the value of a QLAC will be ignored when determining required minimum distributions.
Other QLAC Contract Requirements - QLACs may be purchased from an insurance company by a 401(a) qualified defined contribution plan, 403(a) and 403(b) plans, a governmental 457(b) plan (collectively, the defined contribution retirement plans), or a traditional (not Roth) IRA. The contract (or a rider or endorsement) must state it is a QLAC and that the premiums and payments will comply with the regulations. QLACs may not have a cash surrender right or other similar benefit. Income under the contract must be derived primarily from contractual guarantees. This means a QLAC does not include a variable contract, an indexed contract or any similar contract. Cost of living adjustments and dividends payments are permitted.
Maximum Premiums - The aggregate premiums paid for a QLAC cannot exceed the lesser of 25% of the particular account that is investing in the QLAC or $125,000. The $125,000 dollar limit applies to premiums paid for QLACs under all defined contribution retirement plans and IRA accounts. The 25% limit applies separately to each defined contribution retirement plan but on a combined basis for all traditional IRAs. The value of QLACs held by the account is taken into account to determine the 25% limitation.
If premiums exceed the maximum, the excess must be returned to the non-QLAC portion of the account by the end of the calendar year following the calendar year in which the excess premium was paid to avoid loss of QLAC status.
Payments From a QLAC - Generally, only life annuities may be paid from a QLAC to the employee and after his or her death, to his or her surviving spouse or a non-spouse beneficiary. Non-spouse beneficiaries are subject to limitations on the percentage of the employee’s benefit that may be paid depending on the difference in age between the employee and the non-spouse beneficiary.
Return of Premium - A QLAC may have a return of premium provision in lieu of a survivor annuity under which, a beneficiary would be paid the excess of the total premium payments over the total annuity payments made under the QLAC.
Conclusion - QLACs may provide a strategy for employees to mitigate longevity risk in defined contribution retirement plans and traditional IRAs. Plan sponsors are not required to offer a QLAC as an investment option, but may want to do so to enable employees to better plan for their retirement. However, it may be necessary to amend defined contribution retirement plans to take advantage of this option. If you have any questions about QLACs, or any other employee benefit matter, please contact King & Spalding.
*Employee Benefits Consultant