Inheriting a QLAC Death benefit Tax question?

[RedRider]

Bogleverse,

My DW inherited her father's IRA (held at Merrel Lynch) recently which as many will know becomes an Inherited IRA with a 10 year window to draw down the funds. As part of that inherited IRA, her father held a deferred annuity that was purchased with IRA funds thus making it a "Qualified Longevity Annuity Contract". Additionally, when he purchased the QLAC, he also purchased a "death benefit rider". Based on the details below, I am trying to determine the tax treatment of a death benefit payout that is nearly double the "fair market value" of the underlying annuity.

DETAILS:
-Deferred annuity purchased in 2009
-Maturity date 2028
-he passed away in 2023 @ 83 prior to starting annuity payments
-Purchase price (basis) $130,000
-Cash surrender value $154,894
-Account value on 31 Dec 22: $159,017
-Enhanced Death Benefit: $294,970
-The Merrel Lynch advisor advised having the death benefit payout placed inside the Inherited IRA

QUESTION: What is the tax treatment of the death benefit payout? Is it appropriate that it was placed in the IIRA (and therefore needs withdrawn in the 10 year window)? Or, is it ordinary income or some other possibility?

I have searched the web and IRS pubs but nothing seems to address the "death benefit payout" scenario.

Thanks in advance!

Cheers
Red Rider

[Alan S.]

Bogleverse,

My DW inherited her father's IRA (held at Merrel Lynch) recently which as many will know becomes an Inherited IRA with a 10 year window to draw down the funds. As part of that inherited IRA, her father held a deferred annuity that was purchased with IRA funds thus making it a "Qualified Longevity Annuity Contract". Additionally, when he purchased the QLAC, he also purchased a "death benefit rider". Based on the details below, I am trying to determine the tax treatment of a death benefit payout that is nearly double the "fair market value" of the underlying annuity.

DETAILS:
-Deferred annuity purchased in 2009
-Maturity date 2028
-he passed away in 2023 @ 83 prior to starting annuity payments
-Purchase price (basis) $130,000
-Cash surrender value $154,894
-Account value on 31 Dec 22: $159,017
-Enhanced Death Benefit: $294,970
-The Merrel Lynch advisor advised having the death benefit payout placed inside the Inherited IRA

QUESTION: What is the tax treatment of the death benefit payout? Is it appropriate that it was placed in the IIRA (and therefore needs withdrawn in the 10 year window)? Or, is it ordinary income or some other possibility?

I have searched the web and IRS pubs but nothing seems to address the "death benefit payout" scenario.

Thanks in advance!

Cheers
Red Rider

Any inherited IRA distributions are taxed as ordinary income, except to the extent FIL had basis in his IRA. The question is when the inherited IRA distributions must be made and in what amount.

First off, the structure of a QLAC has many options and the IRS Regs are very complex. Further, the proposed IRS Regs for the Secure Act impact inherited QLACs as well. Since QLACs were not available before 2014, assuming that this is actually a QLAC, my guess would be that a prior deferred IRA annuity that was subject to RMDs was able to be transferred to a QLAC before the end of 2016, and that the annuity was titled as a QLAC at that time. QLAC riders might have included a return of premium (ROP) and/or enhanced death benefit.

Does the advisor seem knowledgeable on QLACs and was the advisor involved with the original purchase?

Under the Secure Act, FIL passed before the QLAC starting date (usually around age 85), but after his RBD (required beginning date) which was about 13 years ago. As a non spouse beneficiary who does not qualify as an EDB, you would be subject to the 10 year rule, but because FIL passed post RBD, wife would also be subject to annual beneficiary RMDs in years 1-9) (2024-2032) using her single life expectancy and would have to drain the inherited IRA annuity in 2033.

Your wife should not have to worry about a 2023 RMD for FIL since a QLAC is exempt from RMDs for years before payout begins. Generally, to level out the tax burden, she might want to take annual distributions over 11 years (2023-2033) on a ratable schedule (1/11, 1/10, 1/9 ect) and these would exceed her annual RMDs, but would eliminate a large taxable distribution in 2033 which would otherwise result from the actual RMDs being lower and leaving a large balance in 2033.

The only possible option better than the 10 year rule resulting from the balance being transferred to an inherited IRA might be a life annuity for your wife. I don't know if this is an option here, but she might ask the advisor.

DId wife also inherit a non QLAC IRA, also subject to the 10 year rule? If so, is she the sole beneficiary of each plan?

[RedRider]

Any inherited IRA distributions are taxed as ordinary income, except to the extent FIL had basis in his IRA. The question is when the inherited IRA distributions must be made and in what amount.

First off, the structure of a QLAC has many options and the IRS Regs are very complex. Further, the proposed IRS Regs for the Secure Act impact inherited QLACs as well. Since QLACs were not available before 2014, assuming that this is actually a QLAC, my guess would be that a prior deferred IRA annuity that was subject to RMDs was able to be transferred to a QLAC before the end of 2016, and that the annuity was titled as a QLAC at that time. QLAC riders might have included a return of premium (ROP) and/or enhanced death benefit.

Does the advisor seem knowledgeable on QLACs and was the advisor involved with the original purchase?

Under the Secure Act, FIL passed before the QLAC starting date (usually around age 85), but after his RBD (required beginning date) which was about 13 years ago. As a non spouse beneficiary who does not qualify as an EDB, you would be subject to the 10 year rule, but because FIL passed post RBD, wife would also be subject to annual beneficiary RMDs in years 1-9) (2024-2032) using her single life expectancy and would have to drain the inherited IRA annuity in 2033.

Your wife should not have to worry about a 2023 RMD for FIL since a QLAC is exempt from RMDs for years before payout begins. Generally, to level out the tax burden, she might want to take annual distributions over 11 years (2023-2033) on a ratable schedule (1/11, 1/10, 1/9 ect) and these would exceed her annual RMDs, but would eliminate a large taxable distribution in 2033 which would otherwise result from the actual RMDs being lower and leaving a large balance in 2033.

The only possible option better than the 10 year rule resulting from the balance being transferred to an inherited IRA might be a life annuity for your wife. I don't know if this is an option here, but she might ask the advisor.

DId wife also inherit a non QLAC IRA, also subject to the 10 year rule? If so, is she the sole beneficiary of each plan?

Alan,

Thank you for the response.

My best attempt at answers:
-The advisor was involved in the purchase but I am uncertain of his expertise but will find out.
-Yes, she did inherit a non QLAC IRA that indeed is subject to the 10 year rule. (Approx $300,000 combined with QLAC EDB approx $600,000).
--Since FIL passed away in Jan, we took his 2023 RMD from the tIRA
--I am 57 and DW is 54. In order to drawdown the IIRA $600k over ten years, we will try to thread the needle of being forced into the 24% bracket. Even with a projected 10% ROI, it appears we will just be able to manage doing this.

FURTHER QUESTION: You do not mention and my greatest concern is that the "Death Benefit" would have to be distributed as a lump sum this year rather than retaining it within the IIRA which the Merrel Lynch advisor guided. Assuming it is a true QLAC, is retaining it in the IIRA the correct assumption?

Cheers
Red Rider

[Alan S.]

The following is copied from the IRS Secure Act proposed Regs with respect to inherited QLACs:

(v) Return of premiums--(A) In general. In lieu of a life annuity payable to a
designated beneficiary under paragraph (q)(3)(i) or (ii) of this section, a QLAC
may provide for a benefit to be paid to a beneficiary after the death of the
employee up to the amount by which the premium payments made with respect
to the QLAC exceed the payments already made under the QLAC

and

(C) Timing of return of premium payment and other rules.
A return of premium payment under this paragraph (q)(3)(v) must be paid no later than the
end of the calendar year following the calendar year in which the employee dies.
If the employee's death is after the required beginning date, the return of
premium payment is treated as a required minimum distribution for the year in
which it is paid and is not eligible for rollover.

The "enhanced" death benefit from a return of premium in this case where no annuity benefits were paid during his life would be the amount of his premium payment, roughly 130k, which was the apparent QLAC limit at the time of QLAC purchase. Therefore, it is possible that prior to the end of 2024, at least 130k will be distributed from the inherited QLAC. While not particularly conversant with QLACs, it is possible that a large inherited IRA distribution of at least the premium under a Return of Premium (ROP) will result in a sizeable 2024 (or even 2023) beneficiary RMD. As a non spouse beneficiary no part of any distribution is eligible for rollover.

Again, the actual details of this particular QLAC are only known to the insurance company and your wife is certainly entitled to a complete explanation so you can do some tax planning.