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Possible Roth IRA Expansion Could Deal A Blow To Annuities

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Congressional tax writers drafting tax cut legislation are considering removing income limits for those investing in Roth IRAs as a revenue-raising tool, a development that some observers say could reduce middle-market interest in annuities.

Insurance industry officials and securities analysts caution that the move may be temporary, and those drafting the tax reconciliation package could go in another direction when they resume talks as Congress reconvenes this week.

Moreover, officials at the American Council of Life Insurers say the potential impact on annuity sales is “pure speculation.”

However, an expansion of Roth IRAs would reduce annuity sales to wealthier individuals who are currently not eligible for Roth IRAs, according to tax experts at Washington Analysis, a securities research firm that caters to buy-side clients such as pension and hedge funds.

Withdrawals from Roth IRAs after age 59.5 are not taxable, while withdrawals from annuities are taxed at the regular income tax rate.

According to Washington Analysis and ACLI tax experts, under current law, single taxpayers with annual incomes in excess of $110,000 and married filers with incomes of more than $160,000 are ineligible for the Roth IRA. Raising or otherwise modifying these limits would prompt additional transfers of money into tax-advantaged Roth IRAs at the expense of traditional IRAs, and at the same time, generate billions in tax revenue as assets in the traditional IRAs are taxed for the first time.

Such a shift of money into Roth IRAs would be a positive for mutual fund companies.

Michael Kerley, senior vice president, federal government relations, at the National Association of Insurance and Financial Advisors, said he doesn’t “want to speculate” on what Congress will do or when its work will be completed. “However,” he said, “I understand conferees are considering adding a provision to the conference report that will raise enough revenue during the period covered by the budget so that the package’s overall tax revenue loss would remain within the budget targets, and therefore not be subject to a budget point of order in the Senate.”

The provision most likely being considered for that “honor,” he said, is a provision allowing high-income taxpayers to convert their traditional IRAs to Roth IRAs.

“The conversion would take place under favorable terms but not favorable enough terms to avoid all the taxes they would pay under current law,” Kerley explains. The “one-time-only IRA conversion offer” would raise enough revenue to reduce the overall revenue loss of the package and maybe get past the budget point of order in the Senate, although that is by no means certain.

“While the IRA provision would raise revenue in the first few years, it would be a long-term revenue loser to a significant degree and therefore will make our long-term deficit picture worse–unless Congress takes steps to avoid that outcome,” Kerley says.

“A back of the envelope calculation suggests that any expansion of eligibility would be designed to increase contributions to Roth IRAs by a total of roughly $80 billion dollars in 2011 and 2012,” Tim VandenBerg of Washington Analysis said.

This increase in contributions multiplied by an estimated 35% tax rate yields about $28 billion in tax revenue–about the shortfall congressional negotiators need to plug in order to avoid a procedural hurdle in the Senate, he said.

According to several industry marketing people, the impact of the Roth IRA depends on the insurer’s product offerings. One insurance company official says mutual funds dominate the IRA market. That means if an insurance company has a product line offering mutual funds as well as insurance products, the impact of the Roth IRA change will be minimal.

However, both agent and underwriter sources voiced concerned that this could be viewed as a “back door” LSA, or lifetime savings account, a pet project of conservative economists that the Bush administration repeatedly has proposed in its budget but which always has been rejected by congressional tax writers.

Specifically, an Employee Benefit Research Institute study in 2001 cited by one industry official said mutual funds hold 49.9% of IRA assets, followed by brokerage accounts at 31.8%, followed by banks and thrifts at 9.9%, and the life insurance industry at 8.9%. Although this study was completed in 2001, the source said, market shares of the various players have not changed materially since then.

“So, the big winners are the mutual funds and brokerage firms since this will attract more retirement dollars into their products and continue the move away from deferred annuities,” the source said.

Of equal or greater concern of the Roth IRA provision, if enacted, is the “bleed off effect,” the source said. Calling the provision “Roth IRAs on steroids,” this could lead to a “bleed off of funds from 401(k)s.

“The mutual funds are the dominant players in both IRAs and 401(k)s, but insurers are relatively stronger in 401(k)s than IRAs,” the source said, so it is “hard to gauge how much will go into these Roth IRAs vs. 401(k)s.”

But an official at another insurer cautioned: “It’s not clear that the conference committee will buy this proposal, since the long-term negative impact on federal coffers is substantial.”