Reprinted with permission from Employee Benefit Review - November 2014
An ongoing focus for the IRS and the DOL has been trying to ensure that individuals have a regular stream of income for the duration of their lives. In connection with this goal, in July of this year, the IRS released final regulations that allow for the purchase of certain qualifying longevity annuity contracts (“QLACs”) with pre-tax amounts in a defined contribution plan under Section 401(a) of the Code, an individual retirement annuity or account (IRA), a Section 403(b) of the Code plan or an eligible deferred compensation plan under Section 457 of the Code. (At this time, the final regulations do not directly address the use of such contracts in defined benefit plans, however in the preamble the IRS has requested comments regarding allowing an employee to elect a QLAC structure under a such a plan.) These final rules provide an exception to the required minimum distribution provisions in the case of a qualifying contract that is being purchased using the plan or IRA assets. The rules also set forth the many requirements for a longevity annuity contract to be a qualifying longevity annuity contract.
A longevity annuity is a type of annuity that is not scheduled to begin making payments until a person has attained an advanced age. The annuity then allows for an income stream from that advanced age until the death of the annuitant. The goal of such an annuity is to help assure that an individual does not outlast his or her retirement income. However, under the required minimum distribution rules (“RMD”) discussed below, such contracts can have an adverse impact on the account’s ability to be paid out over time. In particular, the amounts tied up in a longevity annuity contract may have to be included in the total used to determine the minimum distribution amount, thereby making the liquid assets be distributed faster. This seemed to undermine the goal of creating a lifetime income stream. Thus, the IRS proposed rules about QLACs two years prior to finalizing them this past July. These final regulations permit a narrow modification to certain of the required minimum distribution rules with respect to amounts used to purchase qualifying deferred annuities that begin at an advanced age. Prior to annuitization, the value of these QLACs is excluded from the amount taken into account to determine the required minimum distribution.
In general, Section 401(a)(9) of the Code requires that distribution of a participant’s account must begin by April 1 of the calendar year following the later of (1) the calendar year in which the individual turns age 70½ or (2) the calendar year in which the employee (who is not a 5% owner) retires. The rule generally provides that the entire interest, if not already paid out, must be distributed over the life expectancy of the participant or the life expectancies of a participant and a designated beneficiary. Section 401(a)(9)(B) prescribes the required minimum distribution rules where a participant dies before his or her entire interest is distributed.
Under the tax regulations set forth in 1.401(a)(9)-6, if an annuity contract held under a defined contribution plan has not been annuitized, the value of the contract is included in the account balance used to determine the amount of the required minimum distribution. If the annuity contract has been annuitized, in addition to other requirements set forth in Section 1.401(a)(9)-6 of the regulations, the distributions must satisfy the minimum distribution incidental benefit (“MDIB”) requirements. If the beneficiary of a plan account is a spouse, the distributions are deemed to satisfy the MDIB requirements. However, if there is a different beneficiary, the MDIB requirement is not satisfied unless the periodic annuity payment payable to the survivor does not exceed an applicable percentage of the amount payable to the employee and set forth using an IRS specified table. The final regulations create an exception to these complex distribution calculations with respect to certain annuities that meet a multitude of requirements.
As with many exceptions allowed by the IRS, there are many requirements imposed on a QLAC in order for it to receive the favorable treatment with respect to the minimum distribution calculations. First, the IRS has imposed a premium maximum on the amount that may be used to invest in a QLAC. The amount of the premiums paid on any given day cannot exceed the lesser of 25% of the retirement plan account or $125,000. This maximum dollar amount will be adjusted for inflation over time. The maximum allowed is reduced by each premium payment to the QLAC or any other contract intended to be a QLAC. While the value of the QLAC is not included in determining RMDs, the value of the QLAC is permitted to be included in the account balance for purposes of applying the 25% limit. The final regulations also provide a limited correction if the premium limits happen to be exceeded so long as the excess premium is returned to the non-QLAC portion of the account by the end of the year following the year in which the excess premium was paid.
The IRS also specified a maximum age for commencement of a QLAC payout. A QLAC must commence payment by the first day of the month next following the employee reaching age 85. It can be scheduled to start earlier, however. The regulations provide that this maximum age may be adjusted over time to reflect mortality.
As well, a QLAC may only provide for fixed payments (no variable annuity or indexed contracts). It can allow for a cost of living adjustment. The QLAC cannot have a commutation benefit or cash surrender value, but it may permit a return of premium. Such return may be paid as a single sum death benefit paid to a beneficiary in an amount equal to the excess of the premium paid over the payments made to the employee or the employee and surviving spouse, if applicable. It must be paid no later than the end of the calendar year following the year of the death of the employee, or the employee and spouse, if applicable.
The final regulations set forth disclosure requirements that must be met for a contract to be a QLACs. When the contract is issued it must notify the employee that it is intended to be a QLAC either in the contract or a rider to the contract. If a certificate is issued under a group annuity contract, this requirement is satisfied if the certificate, when issued, states that the employee’s interest is intended to be a QLAC.
Finally the final regulations require annual reporting by issuers to both the IRS and employees. The items to be reported include information regarding the issuer and how to contact the issuer, information about the individual in whose name the contract has been purchased, and if it was through a plan, the plan name, number and the EIN of the plan sponsor. As well, information about both the premium payments and the contract payments will be required to be reported.
The goal to help individuals maintain an income stream throughout the golden years is laudable. The idea of allowing an exception to the RMD calculation for a QLAC certainly is one way to help meet that goal. However, as indicated above, the final regulations contain numerous requirements and possible traps in order to achieve the requisite status under the RMD rules. Given all of these requirements and the overall complexity of explaining annuities generally to participants, it remains to be seen how quickly plan sponsors adopt these vehicles in their plans and even if they are permitted under the plan, how quickly participants embrace these products.