More Guidance Needed to Help Participants Use QLACs

In a letter to the IRS, industry representatives say a couple of clarifications would help more DC plan participants take advantage of QLACs.

The American Benefits Council and seven other industry groups or providers have written a letter to the Internal Revenue Service (IRS) to recommend two items for inclusion in the 2016-2017 Priority Guidance Plan relating to qualifying longevity annuity contracts (QLACs).

In particular, the groups say guidance is needed to clarify how the limitations on QLAC premiums apply when a participant in a qualified plan wants to purchase a QLAC via a direct rollover because the plan does not offer one, and clarify how the regulations apply following a divorce of the QLAC owner if the contract was originally purchased with spousal benefits.    

In 2014, the U.S. Department of the Treasury issued final rules regarding longevity annuities—aimed at bringing more flexibility to retirement savers using the fixed-income vehicles as a longevity hedge. The final rules make longevity annuities more accessible for workplace retirement savers by amending required minimum distribution regulations so that longevity annuity payments will not need to begin prematurely in order to comply with those regulations. Under the final rules, a 401(k) or similar plan, or IRA custodian, may permit account holders to use up to 25% of their account balance or $125,000, whichever is less, to purchase a qualifying longevity annuity without concern about noncompliance with the age 70½ minimum distribution requirements.

A study found QLACs can provide a significant increase in retirement readiness for individuals who live the longest.

The letter notes that it is rare for a defined contribution (DC) retirement plan to offer a QLAC option directly.  As a result, the only way for virtually any DC plan participant to obtain a QLAC is by rolling money out of the plan to an IRA.  QLACs are readily available in the IRA market. 

The groups/providers say when a QLAC is purchased in such a direct rollover transaction, it is not clear whether the regulations limit the purchase to 25% of the individual’s account balance in the DC plan or 25% of the account balance in the individual’s IRAs.  If it is the latter, significant leakage from the plan could occur and the QLAC purchase could be unnecessarily complicated and delayed. 

NEXT: Suggested solutions

The letter gives the following example:

Assume that an individual has a $500,000 account balance in her former employer’s DC plan.  She wants to use 10% of that balance, or $50,000, to purchase a QLAC, but her plan does not offer one.  She decides to roll the money from the plan to purchase a QLAC that also qualifies as an IRA annuity.  However, she currently does not own any IRAs.  If the 25% limit on QLAC premiums applies based on her IRA account balance (which is zero), she will need to roll $200,000 from her plan just to facilitate the $50,000 QLAC purchase.  Moreover, because the regulations measure her IRA account balance as of the prior year-end (which, again, was zero), she will need to roll the $200,000 from the plan to an IRA, wait until the next year, then transfer $50,000 from the IRA to a QLAC that qualifies as an IRA annuity.  After the transaction, the individual would own a QLAC that clearly complies with the intent of the premium limits, but would have unnecessarily moved $150,000 from her plan to an IRA.

The solution to this problem would be for IRS guidance to clarify that the 25% limit applies based on the account balance in the DC plan, the letter states. It notes that the regulations would not need to be amended.

The groups/providers contend the regulations do not address how the QLAC death benefit rules apply if the beneficiary is the owner’s spouse on the date the contract is issued, but because of a subsequent divorce is no longer the owner’s spouse when the annuity payments commence or when the owner dies.

The letter notes that if a beneficiary’s status as a spouse or non-spouse is determined after a QLAC is issued, e.g., on the date annuity payments commence, a contract that was issued with permissible benefits might be viewed as providing impermissible benefits merely because of the divorce.   If a contract that is intended to be a QLAC provides impermissible benefits, severely adverse tax consequences could arise for the participant.

The solution to this problem would be for IRS guidance to clarify that a divorce occurring after a QLAC is purchased but before payments commence will not affect the permissibility of the joint and survivor benefits previously purchased under the contract if a qualified domestic relations order (QDRO) (in the case of a retirement plan) or a divorce or separation instrument (in the case of an IRA) provides that the former spouse is entitled to the promised spousal benefits under the QLAC, the letter says.  It adds that such a clarification would be consistent with a general rule that already exists in the minimum distribution regulations, which provides that a former spouse is treated as a spouse for purposes of the minimum distribution requirements if certain requirements are met.

The letter is here.