To convert or not to convert: That is the question many clients are asking as a result of a recent tax law change allowing higher net worth clients to convert a traditional IRA to a Roth IRA.
This rule change eliminated the $100,000 income limitation on those wishing to convert from the tax-deferred growth of a traditional retirement account to the tax-free growth available in a Roth IRA. However, the income tax bite on the conversion may be too much for some clients, even if the tax is payable in equal installments between 2011 and 2012.
What about a third option, so common to many in the insurance profession, for clients who reject the Roth conversion because of its negative income tax implications?
IRA maximization may be an attractive alternative to a Roth conversion for higher net worth clients who have clearly earmarked their IRA as a "leave on" asset. With this strategy, 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). This critical step of removing the insurance proceeds from the federal estate tax system may give the IRA Max an edge for clients looking to decrease federal estate taxes and increase the amount of wealth left to the next generation.
Assumptions
This analysis includes the following assumptions about a hypothetical married couple who have considered a Roth conversion as a wealth transfer strategy, but who were discouraged by the accelerated income taxes:
o Both spouses are 71 years old and qualify for standard non-smoker rates.
o Their balance sheet includes a $1,000,000, "leave on" traditional IRA, along with a non-qualified investment account of $400,000 (it is generally recommended that the income tax payable on a Roth conversion comes from a source outside of the traditional IRA account).
o The assumed annual rate of appreciation in both accounts is 6%.
o This year's scheduled after-tax RMD will be approximately $28,000.
o Their current combined state and federal income tax bracket is 30%, but the Roth conversion would push them into a 40% bracket in 2011 and 2012.
o Finally, they are expected to incur federal estate taxes at death, regardless of the exemption level when they die, with the full value of both the qualified and non-qualified accounts subject to federal estate taxes at 45%. (We have factored in the income tax deduction for estate taxes attributable to the traditional IRA in scenarios where the Roth conversion is not elected.)
Alternate Scenarios
Our focus centered on how much wealth may be transferred to the next generation under three scenarios when factoring in income and estate taxes:
Maintain Traditional IRA. Maintain the existing traditional IRA, adding after-tax RMDs to the non-qualified account.
Roth Conversion. Convert the 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. These income taxes are paid from the non-qualified account (for reasons discussed above).
IRA Max. Maintain the existing traditional IRA and use a portion of the after-tax RMDs to pay a $26,000 annual life insurance premium. This purchases $1,400,000 of lifetime guaranteed survivorship universal life insurance (SGUL) in an ILIT. (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.)
