SCENARIO NO. 1

Wilbert is 55 and his wife Jean is 50. Jean is in good health, employed full-time and has $100,000 annual income. Wilbert has some health problems and is semi-retired. From part-time consulting he earns about $40,000 a year. Their AGI in 2009 was $122,000. This couple paid for their three children to go to college and are somewhat behind in their retirement savings. Wilbert has a rollover IRA of $120,000 and Jean has a $60,000 rollover IRA from a previous job. They have $100,000 in after-tax savings that they can use for retirement. Neither is entitled to any defined-benefit pension income. Jean participates in her company’s 401(k) plan. Her current account balance is $35,000 and she is contributing $15,000 each year and receiving an annual $5,000 matching contribution. They have come to you for help with their retirement planning. They are especially interested in which type of savings vehicles they should use and whether they should convert either of their IRAs. They think that Wilbert can only work for five more years; Jean would like to retire at age 62.

ADVICE:

KAREN: The first couple is a tough case for me to definitively state that a conversion makes sense. These people are VERY behind on their retirement savings, and I really hate to see them part with any of their nonqualified savings to pay the tax due on a conversion. Should either of them lose their job or have any other type of challenge, they really need the liquidity. I would recommend that Jean increase her 401(k) to the maximum at age 50 of $22,000, and in addition while Wilbert is employed, go ahead and make annual contributions to new ROTH IRA’s for each of them, as they do qualify under the income limits for ROTHs.

JERRY: The life insurance option does not apply for this couple. In this case the math showed a modest advantage to converting if their pre- and post-retirement tax bracket remains the same. They are not in a high income tax bracket now, but may be in a lower bracket in retirement years, which would favor leaving the IRA as is. Part of the question of doing a Roth Conversion has to do with a person’s feelings about current tax rates versus expected tax rates. If you believe that tax rates are going to go up, because of the demands on the federal treasury, then a ROTH Conversion is a great idea. If a client feels their marginal bracket will go down in retirement, then the traditional IRA may provide more money.

SCENARIO NO. 2

Joaquin and Maria are both age 68, retired and in excellent health. They reported $120,000 of taxable income in 2009. They both have rollover IRAs; Maria’s is worth $250,000 and Joaquin’s is $750,000. They do not currently need (or expect to need in the future) distributions from these plans to meet living expenses. The total value of their estate including their home is $3,800,000. Their estate-planning objectives are primarily to benefit their two adult children and three grandchildren, but Joaquin would also like to leave $100,000 to his alma mater. They have heard about the opportunity to convert their traditional IRAs into ROTH IRAs and want to know if this may be a good idea for them.

ADVICE:

KAREN: The second couple is a perfect fit for a ROTH conversion. I am assuming that with $1,000,000 in IRA and a net worth of $3.8 million including the house that there is also substantial nonqualified funds to use to pay the taxes owed upon conversion. They are 2 years from Required Minimum Distributions that they must take and will be substantial. The ROTH would eliminate those RMD’s. Also as their estate plan is to benefit the adult children, the ROTH is a significantly better wealth transfer vehicle. Under an inherited traditional IRA the children would have to take immediate taxable income. With the ROTH, the kids can keep the account intact growing tax free until they retire.

The challenge for this couple is the psychological hurdle of paying the taxes today. If they were to convert the
entire balance they would catapult themselves into the highest tax bracket and over the 2 years they have to pay the taxes. Thus, they would shell out up to $400,000 to the government. That would be a tough pill to swallow for anyone. Most likely my advice would be to back into an amount of tax they would be willing to part with, and then calculate a partial conversion of an amount to create only the tax liability they can stomach, if any.

JERRY: I did an analysis a few years ago on whether I should contribute to a ROTH 401(k) or continue my pre-tax 401(k). The answer surprised me when it came back for the Roth. So I now have a fair amount of my own money in a ROTH 401(k). I’m a fan. But conversion creates a different set of dynamics.

My assumption for Joaquin and Maria is that they will convert the ROTH using IRA money to pay the tax due.
The ROTH will then grow tax-deferred with tax-free distributions not starting before age 90. At 5% per year, the ROTH will have an account value of approximately $2,100,000 at age 90, which would be inherited tax-free by their children. The traditional IRA would have approximately $3,000,000, at 5%, but the children would have to pay tax on the full amount, losing more than $1 million to taxes—of course they could stretch distributions over their lifetime, which would reduce the tax impact. In this instance I believe a ROTH conversion is justified.

But, an idea that some client’s have considered is taking money from their traditional IRA today, paying tax on it, and then using the balance to:

1. Cash out their IRA and pay tax in a single year. They’d use the proceeds to buy a Single Premium Guaranteed Death Benefit Survivorship Universal Life policy. Using my company’s policy, assuming Joaquin is second best class and Maria is best class, a Single Premium of $650,000 ($1,000,000 reduced by 35%) would purchase a fully guaranteed death benefit of $2,360,000. Of course this death benefit would be received free of income taxes by the beneficiaries. The advantage in early years is far greater than the converted IRA.
2. Apply the same strategy to a single premium whole life policy that has a lower initial death benefit, but a growing cash value and death benefit.
3. Purchase a Joint Life SPIA using their $1,000,000 and use the annual after-tax proceeds to make gifts to an ILIT for their children and purchase a Guaranteed SUL policy that is both income tax free and outside their taxable estate.

This is a non-traditional approach to the problem, but may be worth exploring.