Broker Check

Sarah’s Questions: Should I Use an Annuity Strategy to Reduce my Taxes?

My client Sarah (name changed for obvious reasons) is personal finance enthusiast. She reads broadly in the field and graciously sends me clippings with sophisticated questions that send me sprinting to my spreadsheets and deep internet research to address. A little more background is in order. She hates bonds, loves stock, detests taxes, abhors fees of any kind and, due a lifetime of frugal living, has far more money than she will ever spend. At 72, the after-tax portion of her Required Minimum Distributions (RMDs) go straight into her non-qualified investment account which naturally is invested entirely in equities of US companies.
To help people simplify their finances to make it big, I will periodically address Sarah’s questions in writing for all.
Sarah’s most recent missive contained an article from a very reputable personal finance magazine’s website with the headline, “Shrink Your RMDs in 2021 and Beyond,” with a note attached asking me to research and discuss when we next meet. The strategy on which the article focused was the use of Qualified Longevity Annuity Contract or QLAC to remove up to 25 percent of a person’s IRA or $135,000, whichever is less, from the RMD calculation. A QLAC is what is known as a deferred income annuity. It is blessed by the IRS and has some special rules. It must be funded with pre-tax retirement money. The value of these funds is removed from RMD calculations. Income must be taken by the time a person is 85. In theory, since the person does not have a long-life expectancy at that point, it will provide a high level of income at this advanced age and therefore hedge the risk of living a long life.
These contracts are well-reviewed by academic retirement researchers as a way to address running out of money, a task for which they seem well suited for the right person. This, however, is not Sarah’s concern. Sarah wants to minimize her taxes. The question: is this a good strategy for her?
To answer this, I built a spreadsheet. But before I get to that, it’s important to return to a basic principal of money, investing and taxes. It’s not what you pay that matters, but rather what you keep. In other words, I can minimize eliminate my income taxes by eliminating my income. I pay no tax, but I don’t make rent either. Sarah’s goal is not to minimize taxes per se, but to avoid having these taxes erode her pile of money. This is the standard by which this strategy must be judged in her case.
I built a model that compared the effects of investing the $135,000, taking RMDs, paying tax on the RMDs and then investing the after-tax proceeds in a non-qualified investment account with deferring the income in a QLAC. The firs scenario s is exactly what Sarah does. I use her real marginal tax rate, a combined 28 percent and historical rate of return, 8.95 percent. For the QLAC, I secured a quote from a highly rate insurer.
Given these accurate historical assumptions, from today until Sarah reaches 84, she will pay just over $33,000 in taxes. This makes her sad, but it’s only part of the story. Her IRA will be worth just over $225,000 and her new investment account funded with after tax proceeds will be $135,000 for a total value of $358,000. This is of course not guaranteed by any government or insurance company, but that’s neither Sarah’s concern nor her goal.
Her QLAC value is worth $135,000 at 84, and that’s a return of premium should she die. At that point, she can get $18,614 in income for life. This income is taxable. By age 90, she will have recovered her deposit and it’s only then that real returns come from the contract. If she makes it to age 100, she will have an after-tax value of $493,000 with the QLAC. This compares with over $1.2 million from leaving it in the IRA, taking the RMDs, paying full tax and investing the proceeds. Sure, she paid $135,000 in income taxes, something for which many other Americans will be grateful. But her after-tax value is projected to be far greater. In Sarah’s case, the QLAC would be expected to destroy wealth and she should avoid it.
The lesson: Don’t fear taxes but rather seek after-tax total return. It’s not what you pay that matters. It’s what you keep that counts! Keep this simple principal in mind and you will be on your way to making it big.
Michael Lynch CFP® is a financial planner at Barnum Financial Group in Shelton, CT. His book “Keep It Simple, Make it Big: Money Management for Meaningful Life,” offers simple strategies for financial success. His writings can be found at

Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. Barnum Financial Group. 6 Corporate Drive, Shelton, CT 06484, Tel: (203) 513-6000. CRN202302-278745