From the June 01, 2012 issue of Life Insurance Selling

Minimizing IRS Impact With a Roth IRA Conversion

For many clients, converting from a traditional IRA to a Roth can save a considerable amount of money — and help leave a better legacy for the next generation.

Significant client discussions arose when it was announced IRA owners would have two years to pay the taxes due when converting traditional IRAs to Roth IRAs. Due to the market adjustments of the past few years and the ability to defer — or never take — required minimum distributions (RMDs) from Roth IRAs, there has been increased investor interest in Roth IRA concepts. Advisors would be wise to discuss this option with their clients because, as we’ll explore, the financial benefits can be significant.

When circumstances change

As an example, about four years ago, two of my clients and I discussed their existing financial plan in considering the conversion concept. At the time, I suggested converting their traditional IRA, which held $3 million in assets, to a Roth IRA. They would be required to pay approximately $1 million in taxes (federal and state) on the conversion. While their net worth was more than $20 million and $1 million wouldn’t necessarily be a dramatic expense to have access to the benefits of a Roth IRA, it gave them enough pause to pass on the suggestion.

Today, the clients are both 75 years old and have been required to take their RMDs from their IRAs for the past few years. The money lost due to high taxation caused them significant discomfort.

I have been continuously studying IRAs as a charter member of Ed Slott’s Elite IRA Advisor Group and consulted Jane Schuck, vice president of Brentmark Software Company, to get a complete analysis of the best solutions for these clients.

I approached my clients again with the Roth IRA conversion strategy. I recommended converting their traditional IRAs and paying the conversion tax from their other personal funds. The results were astounding. If no changes were made and normal life expectancy was true for all of the beneficiaries of the traditional IRA benefits, the total after-tax value would be approximately $8.6 million in distributions. If the conversion was performed as described earlier, the total benefit to all beneficiaries, based on normal life expectancy, would exceed $34.1 million. With this strategy, two generations of beneficiaries would benefit from income tax-free distributions.

I further recommended they take sufficient funds from the converted Roth IRA in the years ahead to fund the purchase of a survivorship life insurance policy with increasing death benefit values on both their lives to replace the income tax being paid now. The policy would be held in an irrevocable life insurance trust (ILIT) for the benefit of the beneficiaries.

Though this is a sophisticated financial planning strategy, my experience as a Million Dollar Round Table (MDRT) member prompted me to bring client service to the highest level possible.

Time is running out!

Assuming the before-mentioned scenario, if the account was converted to a Roth IRA, my clients would no longer have to take RMDs, except for 2012. Why is this important? The timing of this recommendation can provide serious tax savings. Beginning in 2013, the prospect of new additional taxes will be a reality, and the 3.8% Medicare surtax would also be a factor in their other forms of income received.

Nearly 50% of every dollar they receive would effectively be taxed, especially with an income in excess of $250,000 or more annually.

Not only will a Roth conversion aid my clients immediately, but it will also create a sizeable inheritance for their grandchildren. Because they indicated they were leaving approximately $20 million for their children, they elected to name their two grandchildren as primary beneficiaries on these IRA accounts.

More money, now

In addition to the legacy-building capabilities created by Roth IRA conversions, we can also impact clients’ personal finances almost immediately. For instance, my clients could also decide to convert their IRA and then take distributions as they see fit. That money is tax free and can be used in a variety of ways, including reinvestment or to purchase life insurance — a move many good advisors would suggest.

After conversion, investors would not need to take RMDs. Since they’ve paid tax on the conversion, they also would not need to pay taxes on any distributions they decide to take from the Roth IRA. If my clients were required to remove approximately $130,000 or more per year from their $3 million traditional IRA, they would pay at least $60,000 in taxes annually, leaving them $70,000 for living expenses. After conversion of the Roth IRA, they could take out just the $70,000 and allow the $60,000 that would have originally been paid as taxes to grow tax free and, eventually, be paid out income tax-free.

Look to the future

Though not an immediate benefit, 401(k) Roth options have become popular with clients and advisors. Along with several of my colleagues, I fund qualified plan contributions of our company into a Roth 401(k) on an annual basis instead of the traditional 401(k). When we transfer our funds to our Roth IRA accounts, we will enjoy tax-free growth in the account and tax-free withdrawals as needed.

If a client contributes to a traditional IRA, while he will experience tax deductions, the money invested will become taxable as it is withdrawn once he reaches 70½ years of age. Alternatively, with a Roth IRA, clients can forgo tax deductions now but have all of their distributions tax-free forever. The growth of the investment will stay tax free, plus they would not be forced to take distributions at age 70½, as is true with a traditional IRA.

While my practice serves clients with IRA account balances of various sizes, advisors with clients investing more or less can also use a complete or partial Roth conversion strategy to meet specific needs. You can suggest a Roth conversion to your suitable clients as a way to maximize their return on investment and minimize the amount of tax they need to pay to reach a number of goals. They can use the money to create a legacy and have extra money for retirement and other purposes. While it may not be the right solution for everyone, for those who fit the criteria, there may be a considerable positive impact on their finances, which is invaluable during a time of such economic uncertainty.

One caveat! Be sure to get proper and competent tax and legal advice before broaching this subject with clients. Do keep in mind the possibility of generation-skipping transfer tax issues when attempting to solve multiple generation issues with these concepts.

 

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