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Unfortunately, the problem is that in many cases, those so-called "experts" are wrong.
Run the numbers and you will often come to the conclusion that continued tax deferral benefits only one institution -- the IRS. For a better understanding, here is an example.
Example
John and Mary are both 65 years old. John has $500,000 in his IRA. Mary is his primary beneficiary and their three children are the contingent beneficiaries. John and Mary do not currently need the money. They plan to reinvest the IRA until John turns 70 1/2 and is forced to take his minimum distributions. At that point, John will only withdraw the minimum, and reinvest the after-tax proceeds.
John and Mary believe they are balanced investors, and they expect to earn a 7% to 8% return over time. Because they are a bit conservative, for projection purposes, we'll use 7%. Both are reasonably healthy, and, statistically, at least one will live to age 90. They do not have long-term care insurance, and they believe that John's IRA could be used to handle those types of potential future expenses.
One final assumption: IRA distributions for John and Mary are being taxed at a 25% rate. Let's further assume that tax rates in the future will not increase, which as you know is a dubious assumption at best.
Figure 1, below, explains the future projections of John's IRA. If we assume that John dies before Mary, and she continues to take the required minimum distribution (which most widows do), the spreadsheet stays accurate.
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From Figure 1, we learn the following:
1. John and Mary were reinvesting. They didn't want to take out any distributions, but were forced to beginning at age 70 1/2 . When totaled, they will have taken and paid tax on distributions in excess of $1 million. How would you feel if you had to pay tax on more than $1 million when you didn't want to take the money out to begin with?
2. After they die, the IRS isn't done. Taxes will be collected on more than $900,000 of inheritance money left to John and Mary's three children. If the children stretch their portion of the IRA, the IRS collects on MORE distributions.
3. The net result is that the IRS collects tax on almost $2 million at a minimum, and more if the children stretch their inherited IRAs. What do you think the tax liability will be on $2 Million? $500,000? $600,000? More?
4. Assume the tax is approximately $600,000. How do you think John and Mary would feel about the IRS collecting $600,000 or more on their $500,000 IRA?
Now look at Figure 1 from a tax planning perspective.
In what direction are tax rates headed? If you believe anything other than "up," you likely are fooling yourself. It will be hard to find an expert that believes tax rates will do anything but increase. The baby boomers entering Social Security and Medicare age alone will inflate tax rates.
With tax rates increasing, let's ask a few questions:
1. How much money is John taking out of his IRA today, when tax rates are near historic lows? Answer: $0.
2. How much money is John (or Mary if John passes first) taking out of the IRA in his 80s, after tax rates have certainly increased?
Answer: $50,000 to $80,000 annually.
What do you think of a plan that has you taking nothing from your IRA when tax rates are low, and tens of thousands, if not hundreds of thousands out when tax rates are high?!
Doesn't this seem to be completely backwards? When should you take money out -- when tax rates are low or high? LOW! If you should take money out when taxes are low, then when should John, in our example, be taking money out of his IRA? NOW!
If he takes money out of his IRA now, where should he put it? That's a very good question!
Doesn't it make sense to reposition an IRA into a tax-favored account if possible? What about tax-free? If John wants to move his IRA to a tax-free account, he has three options:
1. Municipal Bonds
2. Roth IRA
3. Properly designed life insurance
Eliminate the municipal bond option, as they pay very low interest. Instead look at transitioning John's IRA into either a Roth IRA or a maximum funded, minimum death benefit life insurance policy.
To keep taxes reasonable, convert the IRA to a Roth (or roll out the IRA to life insurance) over a 10-year period. Figure 2, below, shows the result.
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As you can see in Figure 2, the IRS only collects tax on $711,888. This result is better than the IRS collecting tax on $2 million. However, it is important to note that since the tax is paid up front, there is less money to reinvest.
To identify whether converting to a Roth IRA or rolling the money into life insurance is a good idea, compare the after-tax values of John's current plan to the after-tax values of a Roth conversion or a rollout. Figure 3 shows the result of this analysis, both in end values and year by year.
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*Note: the "Balance to Heirs" figure in the "Current" column is a combination of the taxable IRA balance and the value of the after-tax required distributions that were reinvested over time.
The chart in Figure 3 shows that both the Roth conversion and the rollout to life insurance provide a better result to John and Mary (and their children) than continuing to defer. But which is better, the Roth or the life insurance?
Consider that many life insurance plans now provide free long-term care insurance riders. If the insurance plan illustrated above had such a rider, and it provided results similar to the Roth conversion, which do you think your clients would prefer?
My experience is that most clients prefer the life insurance because they believe that the free long-term care rider is valuable, and the net dollar benefit is very similar to a Roth conversion. Your client gets a tax-free investment environment and free long-term care protection -- a true win/win!
Does continued deferral ever make sense? The answer is yes! If your client is in a position where they will clearly be in a lower tax bracket later on, then deferral is a good decision. You need to be very careful, however, with this line of approach and factor in the overwhelming likelihood of higher tax rates in the future.
Michael D. Reese, CFP(R), CLU, ChFC is president of Centennial Wealth Advisory, LLC. He is also the author of The Big Retirement Lie -- Why Traditional Retirement Plans Benefit The IRS More Than You.
