At the beginning of 2010, a tax law change that gave higher income clients the option of converting a traditional IRA to a Roth IRA created quite a buzz in the financial planning world. This rule change eliminated the $100,000 income limitation for those who wish to convert from the tax-deferred growth of a traditional retirement account to the tax-free growth available in a Roth IRA. For many clients, the income taxation triggered by the conversion is mitigated by the future tax-free growth of the converted Roth IRA. However, the income tax bite of a Roth conversion may be a deal breaker for some clients, even if the income tax is payable in equal installments between 2011 and 2012.
There may be an alternative strategy for higher net worth clients who are intrigued by the tax-free growth of a Roth IRA, but who ultimately reject the Roth conversion because of its negative income tax implications. With this strategy, which we will call here the IRA Maximizer, a portion of the required minimum distributions (RMDs) scheduled to be paid out from a traditional IRA are used to purchase life insurance in an irrevocable life insurance trust (ILIT). By positioning the life insurance in an ILIT, the insurance proceeds are excluded from the gross estate of the insured for federal estate tax purposes.
It is this critical step of removing the insurance proceeds from the ambit of federal estate taxation that may give the IRA Maximizer an edge over a Roth conversion for clients with the dual objectives of decreasing federal estate taxes and increasing the amount of wealth that can be transferred to the next generation.
The IRA Maximizer strategy is specifically designed for higher net worth clients who have earmarked their traditional IRA as a “leave-on” asset (meaning the clients will have no need for distributions from the IRA to meet their projected retirement expenses).
In our analysis, we made the following assumptions about a hypothetical married couple who have considered a Roth conversion as a wealth transfer strategy, but were discouraged by the accelerated income taxes:
· Both spouses are currently 71 years old and are rated standard non-smoker for purposes of life insurance underwriting.
· Their balance sheet includes a traditional IRA with a current balance of $1,000,000, which has been identified as a “leave on” asset.
· Based on IRS life-expectancy tables, the IRA owner is scheduled to begin receiving an after-tax RMD of approximately $28,000 this year.
· Our analysis also includes a second, non-qualified investment account with a current balance of $400,000 since it is generally recommended that the income tax payable on a Roth conversion should come from a source outside of the traditional IRA account.
· They are currently in a combined state and federal income tax bracket of 30 percent, but the conversion of the $1,000,000 retirement account to a Roth IRA would push them into a 40 percent income tax bracket in 2011 and 2012.
· The assumed annual rate of appreciation on both the qualified and non-qualified accounts is 6 percent.
· Finally, our hypothetical clients are expected to incur federal estate taxes at death, regardless of the level of the federal estate tax exemption when they die. We have assumed that the full value of both the qualified and non-qualified accounts will be subject to federal estate taxes at 45 percent, but we have also factored in the income tax deduction for estate taxes attributable to the traditional IRA in scenarios where the Roth conversion is not elected.
We focused on the data point of how much wealth appears to be transferred to the next generation under three different scenarios when income and estate taxes are factored into the equation. The three scenarios may be summarized as follows:
- Maintain Traditional IRA. Maintain the existing traditional IRA, adding after-tax required minimum distributions to the non-qualified account.
- Roth Conversion. Convert the $1,000,000 traditional IRA to a Roth IRA in 2010, triggering $400,000 in combined state and federal income taxes, payable in equal installments in 2011 and 2012. All of the income taxes incurred on the Roth conversion are drawn from the $400,000 non-qualified account (for reasons discussed above).
- IRA Maximizer. Maintain the existing traditional IRA and use a portion of the after-tax RMDs scheduled this year to pay a $26,000 annual life insurance premium. This will purchase $1,400,000 of lifetime survivorship guaranteed universal life insurance (SGUL) in an ILIT. (It is noted that all life insurance guarantees are subject to the claims-paying ability of the insurer, and all required premiums must be paid on time and as scheduled to maintain these guarantees.)
As noted, our focus in each of these three alternate scenarios was how much wealth may be transferred to the next generation when income and estate taxes are factored into the equation. Not surprisingly, the IRA Maximizer leads the way early on because the internal rate of return (IRR) on the death benefit is significantly greater in the earlier years (138 percent IRR at ages 75) and diminishes as the clients near anticipated mortality (9.5 percent IRR at ages 90). Although the Roth Conversion gains relative momentum in the later years, our analysis indicates that the IRA Maximizer still provides a greater amount of after-tax wealth transfer to the clients’ heirs through age 95. As the table and graph below demonstrates, the IRA Maximizer tops the Roth conversion as a wealth transfer strategy by approximately $1.4 million at age 75, $1.1 million at age 85, and $750,000 at age 95.
A True Apples-to-Apples Comparison
In the above analysis, our hypothetical clients rejected the Roth conversion because they balked at the $400,000 income tax liability. However, to truly compare the two strategies, we would redirect the $400,000 that would have been paid in income taxes on the conversion into the life insurance policy. By doing this, we would have doubled the amount of life insurance purchased to $2.8 million. As a result, the net amount to heirs would increase over the Roth conversion strategy by approximately $2.5 million at age 75, $2.1 million at age 85, and $1.3 million at age 95.
Obviously, results will vary with changes in the multiple assumptions made in the analysis, but the ability to remove assets from the federal estate tax system seems to make the IRA Maximization strategy worth considering as an alternative to the Roth conversion, at least for some clients. We also note the following:
· We found the results to be more favorable for married clients who can leverage the life insurance purchase with survivorship life insurance. The results were still favorable for a single female, but slightly less compelling for a single male.
· Increases to the anticipated rate of return will improve the outcome of the Roth conversion over time.
· Similarly, increases in income tax rates incrementally narrow the spreads between the two strategies.
· Conversely, increases in estate tax rates will improve the result of the IRA Maximizer because of the critical removal of the insurance proceeds from the client’s taxable estate.
· Finally, and contrary to our initial expectations, the IRA Maximizer strategy still projected favorably in comparison to the Roth conversion for a younger client who had not reached RMD status.
We did not set out to establish that there is anything flawed about the Roth conversion, or that one strategy is superior in relation to the other. Our objective approach in this analysis was simply to compare the amount that could be transferred to the next generation under these different scenarios when both income and estate taxes are considered.
For financial advisors, the takeaway is that clients should be made aware of all of their options when it comes to estate and financial planning. If you’re not introducing these and other planning concepts and strategies to your higher net worth clients, someone else might.
About the Authors
Richard A. Behrendt is Baird’s Senior Estate Planner. Prior to joining the firm in 2006, he was an estate tax attorney at the IRS for 12 years. As Insurance & Annuity Manager, Blake Panosh oversees the sales and marketing of insurance and annuity products for the firm. Before joining Baird in 2006, he was Marketing Director for PDI Financial Group. Baird does not provide tax or legal advice.