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New! Longevity Insurance for IRAs

Under today's rules, longevity insurance cannot be purchased inside a traditional IRA, but that is set to change soon.

Natalie Choate, 03/09/2012

Natalie Choate will be speaking at a location near you if you live in Las Vegas (4/26/12); Chicago (5/1/12 and 5/10/12); Overland Park, Kan. (5/3/12); Spokane, Wash. (5/8/12); Waltham, Mass. (6/1/12); St. Paul, Minn. (6/4/12); Indianapolis (6/8/12), South Bend (9/20/12), or Evansville (11/16/12), Ind.; San Diego (10/18/12); Atlanta (10/19/12); Iselin, N.J. (10/24/12); or Orlando, Fla. (Jan. 2013). See all of Natalie's upcoming speaking events.

Question: My IRA will provide a comfortable income for me in retirement if I live to the average life expectancy of the mid-80s. However, I'm concerned that I might live "too long." If I live into my 90s or beyond (my aunt just died at age 102), I will run out of money. I'm looking at two options for dealing with this problem.

One is to assume I will live as long as my aunt did, cut way back on my annual spending, and thus be assured my money will last to age 102. The problem with that approach is, if I then don't live that long I will have reduced my standard of living for no reason. (I am not interested in leaving an estate for my heirs.)

The other option I'm looking at is "longevity insurance": Using a portion of my money now to buy an annuity (stream of income) that will not start paying me until I'm in my mid-80s. With that type of annuity, I'm protected if I live "too long." Even though that costs me some money up front, and that money is "wasted" (I get zero return) if I die in my mid-80s, the cost is acceptable. Because the risk is spread out over the whole population of individuals who buy these contracts, the amount I have to spend for the protection costs less than the amount by which I would have to reduce my spending if I were to finance the entire risk of my living too long by myself.

Can I buy this type of insurance inside my IRA?

Answer: You can't now--but you will be able to soon.

Here's why you cannot buy longevity insurance inside your traditional IRA right now. As explained in my February 2011 MorningstarAdvisor column, the IRS has two sets of minimum distribution rules, one for "defined contribution plans" and the other for "defined benefit pension plans." Normally IRAs are subject to the defined contribution rules. Under those familiar rules, the minimum required distribution each year (beginning the year you reach age 70 1/2) is determined by dividing the prior year-end account balance by a "divisor" from the Uniform Lifetime Table based on your age.

But when all or a portion of an IRA is used to purchase an annuity, the IRA (or the portion so "annuitized") switches out of those familiar rules and becomes subject to the defined benefit rules instead.

Note this important distinction: The special defined benefit rules do not apply to the typical deferred variable annuity contract many participants hold in their IRAs, unless and until the contract is actually "annuitized." The defined benefit minimum distribution regime only applies once the insurance company locks in to pay a stream of payments starting at a certain time and continuing for a stated period of years (or for life). The typical deferred variable annuity contract is a "wrapper" to accumulate investment value. The insurance company may guarantee a certain minimum rate of return, and that it will convert the accumulated value to an actual annuity (stream of periodic payments) at some time in the future, but until that switch is made, the contract is simply treated as an asset inside a defined contribution plan, subject to the familiar defined contribution minimum distribution regime.

Longevity insurance, however, is not treated like the typical deferred variable annuity contract. With longevity insurance, the company is promising to pay a stream of annuity payments beginning at a fixed time (typically age 85) and lasting for life. Thus, these contracts are governed by the defined benefit minimum distribution rules, and that's the problem: The defined benefit rules allow the IRA owner to purchase many types of annuity contracts inside the IRA, provided that the annuity payments start no later than the participant's required beginning date, i.e., April 1 of the year after the year the participant reaches age 70 1/2.

Thus, under today's rules, "longevity insurance" cannot be purchased inside a traditional IRA because it does not comply with the minimum distribution rules. It starts payments at age 85, not age 70 1/2. If you want to buy insurance of this type right now, you have to buy it with your "outside" (taxable) dollars or in a Roth IRA. Because Roth IRAs do not have to pay minimum required distributions during the participant's life, the Roth IRA could buy an annuity contract that doesn't start paying until age 85.

But the IRS has been alerted to the problem. In 2010, the IRS requested comments on how to help retirees get lifelong income from their retirement plans. Commentators pointed out, among other issues, the impediment posed by the existing rules. The IRS has responded by issuing a proposed amendment to the minimum distribution regulations that would permit a portion of an individual's account balance to be used to buy the type of longevity insurance annuity you are looking for. Specifically, the proposal would permit up to $100,000 (or, if less, 25% of the participant's account balance) to be used to purchase a "Qualifying Longevity Annuity Contract" (QLAC).

Here are the features of a "QLAC" as outlined in the proposed regulation:

--The contract must not be a "variable" or "equity-indexed" type of contract. In other words, the annuity payments must be fixed in amount, not dependent on the value of an underlying investment portfolio.

--Distributions must begin no later than age 85.

--As with all IRA-owned annuities, the periodic payments must be paid at least annually (typically monthly payments are used), and the payments must be level throughout the participant's life, other than certain permitted cost-of-living type increases.

--The contract cannot provide any commutation or cash surrender right.

--There can be no death benefit other than a continuation of the same payments to the participant's surviving spouse for life, or the continuation of payments to a nonspouse designated beneficiary. The level of continuing payments to a nonspouse beneficiary may have to be smaller than the payments the participant was entitled to if the nonspouse designated beneficiary is more than 10 years younger than the participant.

The proposed regulation was just issued Feb. 3, 2012, and there may be comments offered and further tweaking, but presumably this regulation will be finalized within the next year. I would expect brisk sales of these contracts to IRAs once the proposed regulation becomes final.

Resources: For the existing IRS rules on annuities in IRAs, see Reg. § 1.401(a)(9)-6 and Natalie Choate's Special Report: When Insurance Products Meet Retirement Plans, downloadable at http://www.ataxplan.com. For the new proposed rule, see Prop. Reg. § 1.401(a)(9)-5 and -6, and the Preamble to the Proposed Regulation, Fed. Reg. Vol. 77, Nol. 23, p. 5443, all issued 2/3/12.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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