Add Excitement To Your IRA With A QLAC Old-Age Annuity
With a fixed-income backstop for later years, you can be more adventurous with the rest of your retirement investing.
Stocks will probably do a lot better than bonds. But retirees can’t be sure of that, and especially can’t be sure they won’t get killed by a bad sequence of returns. If you have an all-stock portfolio, and if there’s a prolonged bear market at the beginning of your retirement, you could be in very bad shape at age 80.
So retirees almost inevitably wind up with a large dose of those lousy bonds, just for protection.
But there’s a better form of protection, and it allows you to put more pizzazz in your asset mix. Paradoxically, the excitement comes via what may be the most boring investment on the planet, a fixed-income annuity.
The topic is longevity insurance, a policy that starts paying off late in life—such as at age 80—and continues as long as you do. This essay will explain the economics of this product, and why you’re likely to be better off owning it inside a retirement account than outside.
You are permitted to sink up to $135,000 of an IRA into one of these things, provided the sum doesn’t exceed a fourth of total IRA assets. Eligible annuities go by the acronym QLAC, for qualified longevity annuity contract.
Example: Harry, 65, puts the max into a single-life policy that starts at age 80. The going payout rate is close to $2,000 a month. So, if he makes it to 86 he’s breaking even, and once he hits 92 he has doubled his money. If he dies before age 80 his investment goes down the drain.
Given a material risk that Harry won’t collect anything, or will collect for only a few years, the $24,000 annual payout is not overly generous. Still, the deal is a good one because it takes the edge off Harry’s anxiety about outliving assets. It beats buying a collection of bonds to accomplish the same result.
Compare: Instead of sending $135,000 to an insurance company, you could guarantee a $24,000 annual payout lasting from age 80 to age 100 by purchasing 20 zero-coupon Treasury bonds. But, with interest rates low, that bond ladder is very, very expensive. It will run you roughly $335,000.
With either Treasuries or the annuity in place, Harry can take risks with the rest of his portfolio. The reason for preferring the annuity to the bonds is that it leaves him with $200,000 more in his pocket today. He can put the $200,000 in stocks. He can live (comparatively) high on that hog.
There is, of course, a downside to buying an annuity. If you die owning bonds, your heirs get the bonds. If you die owning an annuity, your heirs get nothing.
Well, how important is it to you to make your heirs rich? Maybe you’ll be happier possessing the wherewithal to visit your grandchildren than arranging to leave them money.
Once you are persuaded that the annuity is a good deal, you must make a decision: Hold this object in an IRA or in a taxable account? It turns out that the former course is likely to be much more rewarding.
That will surprise some people. Annuities, after all, have an element of deferral (in our example, starting 15 years later), and IRAs are all about deferral. So it would seem that stuffing the annuity into the IRA is a waste of the IRA’s virtue.
But there’s a reason the IRA is a good location for an annuity, at least if your plan with the outside dollars is to invest in the stock market. Dollars in the IRA are worth less than dollars outside, because you have to share IRA dollars at some point with the tax collector. It’s better to have the low-value IRA dollars invested in the low-returning annuity and reserve the high-value outside dollars for investing in high-returning stocks.
To see the location effect, consider what happens under some mid-range assumptions about lifespans and stock market returns.
Our hypothetical Harry, 65, has $135,000 in an IRA that could go into either a stock index fund or the age-80 annuity. He has another $135,000 in a taxable account that could go into either. Beginning at age 72, he will spend $7,000 a year from this pair of assets. Beyond that, whatever is left of this $270,000 piece of Harry’s wealth is stockpiled until ten years after his death.
In real life, the money would probably be spent sooner. I assume stockpiling simply in order to make a fair comparison between two very different sequences of cash flows. It also allows heirs to squeeze the last drop of tax dodging out of the IRA.
We’ll look at two longevity outcomes: Harry lives to 80 or lives to 92. For now, we’ll assume that the stock index fund yields 1.7% and appreciates at a 3% rate.
Plan A: Harry uses outside assets to buy the annuity. If he lives to 92, he deducts the annuity cost over 9.5 years, as spelled out in IRS Publication 939. If he dies at 80, I hypothesize, his family is able to make full use of a $135,000 deduction for a loss on the annuity. This would happen if Harry either is able to do a deathbed Roth conversion of that amount or has a spouse who does the conversion.
Harry pulls out enough from the IRA to generate the $7,000 a year of aftertax spending money. If the IRS rule on minimum withdrawals forces him to take out more, the excess goes into a taxable account invested in the stock index fund.
Heirs keep the taxable account going for a decade, paying tax on dividends and, at the end, a capital gain. They also keep the IRA going for ten years, then cash that out, paying tax at ordinary-income rates.
I calculate that the heirs walk away with $211,000 if Harry dies at 80 and with $567,000 if he dies at 92.
Plan B: Harry uses the IRA to buy the annuity and uses $135,000 of outside assets to buy the stock fund. If he dies at 80, the IRA delivers no taxable income and there’s no deduction for the annuity cost. If if he lives longer, there’s again no deduction; the entire $24,000 a year is taxed as an IRA withdrawal, at the ordinary-income rate.
Between 72 and 80, Harry is liquidating shares of the stock fund to supply $7,000 a year of spending money. After 80, he’s got enough coming in from the annuity that he can add money to the stock fund. He pays tax on the dividends but doesn’t sell fund shares unless he has to.
I calculate that under Plan B the heirs get $279,000 if Harry dies at 80 and $684,000 if he dies at 92. Plan B leaves the family between 20% and 32% better off than Plan A.
What if stocks appreciate at better than 3%? Plan B’s advantage grows. If they do worse? B still wins, unless you cut the appreciation to 0%. With stocks dead flat for the next 37 years, Plan A ekes out a 1% advantage, but only if Harry lives to 92.
I assumed a 35% combined state and federal tax rate on ordinary income and 20% on dividends and capital gains. Higher tax rates make Plan B even more advantageous.
My calculations assume a step-up in basis that exempts from income tax any capital gains unrealized at death. The step-up does more good for Plan B than Plan A. There is talk of repealing step-up, but if that happens I think Congress will go after rich people only, not the small fry who buy $135,000 annuity policies.
In short, you can concoct scenarios in which Plan B turns out slightly worse, but they involve unlikely returns and tax changes. I think moderately prosperous 65-year-olds should seriously consider longevity policies, and should put them inside an IRA.