The “Failsafe” Strategy is a way to manage a traditional (not Roth) IRA account so that the IRA assets provide income to a retiree for life, no matter how long he or she lives. The Failsafe Strategy assures the person cannot outlive their IRA savings.
This retirement planning approach employs a new type of life annuity called a Qualified Longevity Annuity Contract or “QLAC.” If an annuity meets the IRS definition of a QLAC, IRA distributions taken to pay the QLAC premium are not taxable to the recipient. The QLAC annuity start date can be deferred to age 85 of the beneficiary.
To implement the Failsafe Strategy, an IRA owner purchases a QLAC, then divides retirement into two planning phases:
- Phase I - From the start of retirement to the date before when the QLAC annuity payments begin (e.g., from 70th birthdate up to 85th birthday). During this period, the IRA owner withdraws funds from their IRA in approximately equal monthly installments until the IRA balance is nearly dissipated.
- Phase II - Beginning at the QLAC annuity start date to date of death (e.g., 85th birthday until the age at passing). During this Phase, the QLAC takes over providing retiree income. The IRA owner receives monthly QLAC annuity payments until they die.
For many IRA owners, the maximum allowable QLAC premium (the lesser of 25% of IRA assets or $135,000) can buy a QLAC lifetime annuity with a benefit greater than or equal to the Phase I IRA payments. Thus, with proper planning, benefits received during Retirement Phases I and II can, when combined, create a level, secure, lifetime stream of income, one that the benefit recipient cannot outlive. To see how the strategy outlined above might work for you, try the QLACGuru FailsafeSM Maximize Income Calculator Page. If you prefer a pencil and paper approach, click to see Maximize Income Infographic on how to estimate FailsafeSM income.
ARTICLE TEXT UDATED 11/4/2020:
This article describes a strategy that assures that a retiree will never run out of money during his or her retirement, no matter how long retirement lasts. The strategy will be outlined by following a prospective retiree, Ian.
Ian’s retirement savings are in an Individual Retirement Account (“IRA”). Ian’s IRA includes funds that his employer contributed when it converted its pension plan from a defined benefit to a defined contribution plan. Of course, Ian will collect social security benefits, and they are the foundation of his retirement income. Unfortunately, Ian’s annual social security payments of $30,000 fall short of meeting his estimated cost of living of $50,000 to $60,000 per annum.
Ian has been a hard worker all his life but never could save a large sum of money. He attempted to be an investor by buying and selling homes in addition to his day job. That effort turned into a major loss in 2008. His wife is deceased, and he has two grown children – one in the Armed Forces and the other a teacher. Ian also has one grandchild. He owns his home, which is subject to a modest mortgage. He is 69 and plans to retire next year. Ian has deferred his social security benefits until in the coming year. His IRA account balance is $500,000.
Four Percent Rule In Current Environment
Fortunately, Ian is on good terms with his brother-in-law, Fred, a CPA. Fred agreed to sit down with Ian and see how to make his IRA last a lifetime. First, Fred relayed that there is an old rule of thumb that says that it is safe to withdraw 4% per year from your IRA and not run out retirement money. For Ian 4% equals $20,000. Adding the $20,000 to the $30,000 of social security benefits, Ian has $50,000 of spending money - the low end of his estimated retirement needs. Unfortunately, Fred added that the old rule of thumb was conceived in an era when interest rates were much higher than today. The conventional wisdom is that retirees should weight their investments towards bonds and other interest income investments to avoid the volatility of equities. Today, prudent planning suggests assuming a 2% rate of return in the IRA during retirement. With that rate return, Ian’s IRA will be reduced to zero shortly after he reaches age 100. Ian asked what would happen if the annual IRA withdrawal was $30,000. For example, inflation could occur, and Medicare is likely to become more expensive; besides, he wants the extra $10,000 each year.
If the annual IRA withdrawal increases to $30,000, Fred said, the IRA balance would go to zero by age 89. When Ian seemed relieved, Fred pointed out that current mortality projections show Ian with a 50% probability of living to age 89 or older. That means there is a reasonable chance Ian will outlive his IRA savings if he withdraws $30,000 annually. Fred’s advice at this point was for Ian to look at his expenses and determine where he can cut back. It would not be prudent to take more than $20,000 a year out of his IRA during Ian’s retirement unless or until the IRA earnings exceed the projections.
Fred's 'Failsafe' Idea
The following week, Fred called Ian to say that he had an idea. In his professional reading, Fred had run across a new insurance product, a Qualified Longevity Annuity Contract or “QLAC” for short. Further, there are more than a dozen life insurance carriers offering QLAC annuities. When an annuity contract qualifies under the IRS rules as a QLAC, an IRA withdrawal is tax exempt if used to pay a QLAC premium. QLAC annuity payouts can be deferred as late as age 85 and once begun, must be paid for the life of the beneficiary. The QLAC distributions are fully taxed to the beneficiary but only when paid. The premium amount is limited to the lesser of $135,000 or 25% of the IRA balance. Multiplying 25% times Ian’s IRA balance of $500,000 is $125,000, the maximum contribution limit. (The $ 125,000-lifetime limitation was increased to $135,000 on January 1, 2020, and will increase from time to time after that.) If Ian were to buy a QLAC and defer the payment start date until his age 85, the annual QLAC benefit from a leading insurance agency quoted online would be $33,333 for the rest of Ian’s life.
Running the Numbers
Once Ian turns 85, the $33,333 annuity is greater than his projected $30,000 income needed to top off his Social Security income. Accordingly, the question is what kind of distribution can the IRA support before age 85? In other words, with longevity risk eliminated after age 84 by the QLAC insurance contract, Ian can focus on the remaining IRA assets of $375,000. These assets do not have to support an uncertain lifetime of income, but instead, provide retirement income for a time certain of 15 years - from age 70 through 84. If the post QLAC IRA balance (i.e., $375,000) earns no income, $25,000 can be paid annually until age 85. A 2% earnings rate in the IRA would justify a $30,000 annual distribution in each of the 15 years. Ian has met retirement income targets and is assured of an income for life in addition to his Social Security benefits.
Ian asked, Fred, what is the catch? Why not adopt this “Failsafe” strategy? Remember that the annuity is a lifetime payout, Fred replied. After you die, the QLAC payments stop. Most likely, there will be nothing left over for your children. It is possible to buy a QLAC that guarantees a return of the premium (e.g., Ian’s $125,000 premium) even if you die before scheduled distributions. Of course, such an annuity pays a lower benefit than a QLAC without a guaranteed return of premium. In the event of premature death, it might be tempting to label a QLAC as a poor investment. When a person thinks about a QLAC as an insurance contract that prevents you from running out of money in your old age, it makes a lot more sense. A QLAC is more like a social security benefit than it is like buying a 20-year bond.
Learning About QLACs - Who Should Buy, Who Should Avoid?
Next, Ian wondered – why have I not heard of this before? Shouldn’t everyone buy a QLAC? To begin, Fred said, QLACs were created by a Treasury Regulation promulgated in 2014. It is a new financial product with special tax benefits. People are just beginning to learn about QLACs. Also, not everyone is a good candidate. First, those folks without an IRA or similar savings accounts are simply out of luck. The QLAC premium amounts must come out of an IRA or a similar tax-qualified savings account1. Secondly, individuals with serious health concerns are unlikely candidates for a QLAC. Presumably, persons in poor health or with a limited expected life span will choose not to participate even though carriers will happily take their premium dollars. Finally, QLACs are not necessary for individuals who have ample savings and have no concern about running out assets. Their incomes equal or exceed their spending needs. Most often, these individuals will be planning how their assets are to be distributed upon their passing. On the other hand, QLAC buyers are concerned about their financial resources disappearing in their old age and becoming a burden on their children.
Ian asked Fred about the IRA required minimum distribution rules and how they might affect the Failsafe strategy. Ian had heard that once a person reaches age 72, there must be a minimum distribution from the IRA or severe penalties are imposed by the Internal Revenue Service (“IRS”). The IRS rules divide the life expectancy of a person into the prior year’s IRA balance. The product is the Required Minimum Distribution (“RMD”). Because Ian is making the IRA distributions over 15 years instead of a lifetime, each of Ian’s withdrawals will exceed the RMD for each year through age 84. The QLAC payments occur outside the IRA, so they do not affect the RMD test. Of course, if Ian’s IRA outperforms the 2% assumption, there will be a balance in the IRA at age 85, and that balance will be subject to the RMD test. It is important to note, however, that there is no IRS penalty for withdrawing more than the RMD or even the entire IRA balance.
Shop Around to Buy Best Benefit and Ratings
Fred told Ian there are multiple planning opportunities Ian should evaluate before he decides to purchase a QLAC. This is because a QLAC purchase cannot be undone once contract elections are made and the premium is paid. For example, his QLAC annuity could be decreased by reducing the premium and leaving more money in the IRA. While most carriers have a minimum premium of $25,000 or more, in Ian’s case he could reduce the premium to $112,500 to create an annuity of $30,000. Similarly, Ian could elect for payments to start at age 83 or 84 and keep the maximum premium of $125,000. Since Ian voiced an earlier concern about inflation, he should obtain quotes from those carriers that offer an election to include inflation factors in their QLAC distributions. Since Ian would depend on long term payout from an insurance company, Fred added, Ian should pay careful attention to the carriers' ratings -- even though state regulators are dedicated to assuring carrier promises are kept to policy beneficiaries.
Before concluding their meeting, Fred told Ian that he wanted to share a recent conversation. While at his country club, Fred was discussing the merits of the QLAC product with a stockbroker friend. Fred’s buddy claimed that a QLAC was not necessary – he could create a “synthetic” QLAC by making the right investment choices. For a minute that seemed possible – but then I asked, what if the choices do not work out? Will you or your firm guarantee payments for life? Not surprisingly, my stockbroker friend had no answer.
With that, Fred said, goodnight and happy retirement.
To see how the strategy outlined above might work for you, try the QLACGuru FailsafeSM Maximize Income Calculator Page. For more information about QLACs, including Frequently Asked Questions, Articles, and Links to authoritative information about Longevity Annuities, or links to providers Annuity Quotes, please call (800) 460-4166.
 To the extent Ian had one or more IRA, 401(k), 403(b) or 457(b) type of saving plans; he previously consolidated all of these accounts into a single traditional IRA. Ian did not have nor has a Roth type of savings account.
 Original IRA balance of $500,000 – QLAC premium of $125,000 = After QLAC IRA balance of $375,000.
 After QLAC IRA balance of $375,000 ÷ number of payment years of 15 = available annual distributions of $25,000.
 There are limited options to change the start date of the QLAC payments after a purchase.