HNW Roth Conversion Scenario

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Aug 17, 2010 3:54 pm

Client is 57, married, retired with an older disabled son, daughter just went off to college.

HNW home, fully paid for. 5m in a blue chip stock from former employer. 13m in a balanced account with stocks, funds, munis. 1.2m IRA. His current income is about $500k, from stock dividends and AMT free muni income.

He will never need to take w/d, and can pay the taxes out of cash.

Why not convert the IRA, pay the taxes this year from out of pocket? Any potential drawbacks, other than theories about future taxation on Roth accounts?

Aug 17, 2010 4:25 pm

He could always do the conversion and see if the performance is positive over the next year and few months.  If not then he can recharacterize and be right where he left off.  Otherwise, I like the idea of conversion.  I have had quite a few clients convert at least portions of their IRAs to Roths simply because of not having to take RMDs.

As you mentioned above, he won't need to withdraw on it anytime, this allows for money to grow tax deferred.  I have similar clients that liked this option and with Trusteed Roth IRAs I can be assure that money is not going anywhere soon.

The only potential drawbacks I see are the waiting period of 5 years, paying taxes now (relatively soon), and the potential in the future to be in a lower tax bracket.  Good Luck, and try finding a conversion analysis tool that may run a simulation for you.  My firm has one and it's been great showing both scenarios to prospects with the caveat of having many assumptions.

Aug 17, 2010 5:18 pm

I don't always like the Roth conversion, but in this case I like it because (a) you eliminate the unnecessary mandatory withdrawals of the traditional IRA and (b) there are enough income-generating assets to pretty much guarantee this individual will always be in a high tax bracket.

I'm sure you've already advised him to diversify that $5m blue chip stock holding...

Aug 17, 2010 6:11 pm

You didn't mention anything else about this guy, but a Roth conversion is one of the last things I'd be talking with him right now.  More of an "oh by the way, we ought to do this while we're at it" kind of thing.  According to our program it does generate a better cashflow at age 65 for him.  So, it if he needs the income, it's a good thing.  If he doesn't he'll have more account value leaving it where it is.  Who knows what tax rates are going to do in the future.  Since it's not the bulk of his money or his income, it wouldn't suprise me if a guy like him decided not to pay the IRS $300K+ in taxes and just deal with the RMDs.   

Hopefully I'm not stepping on your toes here or insulting your intelligence as an advisor, but the savings on the Roth conversion is chump change compared to the massive amounts of wealth you can both create and preserve for a guy like this.  If you simply started taking a 5% withdrawal off of that IRA (without converting it) and bought life insurance with it, that $60K a year would turn into about $3.4 million in DB.  I'm sure you know there are ways to get that out of his estate and sheltered from estate taxes. 

That stock is going to cause a huge tax headache for him someday if he wants to liquidate it.  Especially if our wonderful Congressmen and Senators continue to sit on their thumbs.  Nevermind changes in Roth taxation, as of 2011 that stock, whether it pays dividends or not, becomes a much more expensive asset to liquidate.  Cap gains at ordinary income levels makes it much less appealing to him to make a change. 

So, what else have you recommended for this guy, besides the Roth conversion?

Aug 17, 2010 6:15 pm

[quote=loneMADman]

I don't always like the Roth conversion, but in this case I like it because (a) you eliminate the unnecessary mandatory withdrawals of the traditional IRA and (b) there are enough income-generating assets to pretty much guarantee this individual will always be in a high tax bracket.

I'm sure you've already advised him to diversify that $5m blue chip stock holding...

[/quote]

Yes, the highly concentrated holding is something he's seriously considering selling 1/3, keeping 1/3, the other 1/3 going to charity. That charity part could go a long way in offsetting the taxes. The issue is, his CPA told him that he's against Roth conversions, but then never backed it up with any real reasons.

Aug 17, 2010 9:51 pm

In this case I like the idea of partial withdrawals after he is 59.5 and buying second to die life insurance in an ILIT if one of his goals it to leave a leveraged inheritance.  Also, if this was done aggressively it would meet the same goal of lowering RMD's while avoiding taxation all in one year plus it would leave a lot more to his beneficiaries while not being subject to estate tax in the ILIT.

Aug 18, 2010 10:01 am

[quote=I am legend]

In this case I like the idea of partial withdrawals after he is 59.5 and buying second to die life insurance in an ILIT if one of his goals it to leave a leveraged inheritance.  Also, if this was done aggressively it would meet the same goal of lowering RMD's while avoiding taxation all in one year plus it would leave a lot more to his beneficiaries while not being subject to estate tax in the ILIT.

[/quote]

Why wait until hes 59.5?  I haven't run a 72t this year so I don't know what the current rates are, so assuming the w/d rate covers the required premium, why wait?  Picking up the insurance now provides more leverage and alleviates future potential health risks...

Aug 18, 2010 11:59 am

Spaceman, thanks for your comments. Yes, this is an "oh by the way", but conversion in his case needs to be done by year end, from what I understand. I'd encourage him to pay taxes immediately, because I think taxes are going higher, maybe much higher, and will stay that way for decades to come. I base that on my study of historical tax rates over the last 100 yrs, and the massive deficits our states and federal govt are running. 

"The stock", well, he previously had about 13-14m of it, that is where most of the funds came from in his taxable and now very diversified account he has at my firm.

His disabled adult child, is legally not competent, and will never be fully independent. So, some sort of special needs trust seems necessary for sure. 

Other child is college age, and client isn't motivated in making that child a mega millionaire.

Creating wealth, not a priority, paying of estate taxes somewhat.

Wife is not particularly healthy, has medical history, I'm not fully aware of the issues.

Client really only needs 250k of their 500k/600k of current income. All the income is div/interest from stocks and bonds. So, there is a ton of free cash flow, w/o even considering this IRA.

The client is very intelligent, but also is capable of paraylis by analysis. Took 7 yrs of prospecting him, worked together now for 3 1/2 years. He's currently at a point where we can really work together. Performance of his account has been surprisingly good since working with me, due to some luck, avoiding problem bonds/stock sectors, and a dca strategy we employed. He bought in for a decent amount very near the mar/09 low.

Aug 18, 2010 12:04 pm

[quote=BullRunt]

He could always do the conversion and see if the performance is positive over the next year and few months.  If not then he can recharacterize and be right where he left off.  Otherwise, I like the idea of conversion.  I have had quite a few clients convert at least portions of their IRAs to Roths simply because of not having to take RMDs.

As you mentioned above, he won't need to withdraw on it anytime, this allows for money to grow tax deferred.  I have similar clients that liked this option and with Trusteed Roth IRAs I can be assure that money is not going anywhere soon.

The only potential drawbacks I see are the waiting period of 5 years, paying taxes now (relatively soon), and the potential in the future to be in a lower tax bracket.  Good Luck, and try finding a conversion analysis tool that may run a simulation for you.  My firm has one and it's been great showing both scenarios to prospects with the caveat of having many assumptions.

[/quote]

Interesting. I hadn't thought about recharacterization angles. If converted now, he'd have to recharacterize back to traditional by what time? I saw another post, using multiple accounts, multiple asset categories, then recharacterizing the weak performers? Sounds complicated, but intriguing. Another friend discussed doing a non deductible ira for himself, then moving it to roth (doesn't qualify for normal roth due to high income), exploiting a loop hole in the system.

Aug 18, 2010 1:54 pm

If he converted now, and turned his tax return in on time then he gets the tax-filing deadline plus extensions which woul mean he has until October 2011 to see if the Roth conversion was a good idea.  Recharacterizing is a hassle but at least it's not an all or nothing feature.  With multiple accounts asset classes, there is great chance that some or all of those would be better off staying converted, assuming the advisor can perform.

Aug 18, 2010 10:04 pm

[quote=Incredible Hulk]

[quote=I am legend]

In this case I like the idea of partial withdrawals after he is 59.5 and buying second to die life insurance in an ILIT if one of his goals it to leave a leveraged inheritance.  Also, if this was done aggressively it would meet the same goal of lowering RMD's while avoiding taxation all in one year plus it would leave a lot more to his beneficiaries while not being subject to estate tax in the ILIT.

[/quote]

Why wait until hes 59.5?  I haven't run a 72t this year so I don't know what the current rates are, so assuming the w/d rate covers the required premium, why wait?  Picking up the insurance now provides more leverage and alleviates future potential health risks...

[/quote]

Great point on the health risk so I agree.