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Life Health > Life Insurance

Giving a New Twist to an Old Strategy

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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.


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.)

Comparing Results

As noted, we focused on the amount of wealth transferred to the next generation after income and estate taxes are deducted. Not surprisingly, the IRA Max leads the way early on because the internal rate of return (IRR) on the death benefit is significantly greater in the earlier years (138% IRR at ages 75) and diminishes as the clients near anticipated mortality (9.5% IRR at ages 90).

Although the Roth Conversion gains relative momentum in the later years, our analysis indicates that the IRA Max still provides a greater amount of after-tax wealth transfer to the clients’ heirs through age 95. As the table and graph below demonstrates, the IRA Max tops the Roth conversion as a wealth transfer strategy by approximately $1.4 million at age 75, $1.1 million at age 85, and $750,000 at age 95.

A True Apples-to-Apples Comparison

In the above analysis, our hypothetical clients rejected the Roth conversion because they balked at the $400,000 income tax liability. However, to truly compare the two strategies, we would redirect the $400,000 that would have been paid in income taxes on the conversion into the life insurance policy. This would double the amount of life insurance purchased to $2.8 million, resulting in an increased net amount to heirs of approximately $2.5 million at age 75, $2.1 million at age 85, and $1.3 million at age 95.

Additional Considerations

Obviously, results will vary with changes in the multiple assumptions made in the analysis, but the ability to remove assets from the federal estate tax system seems to make the IRA Max strategy compelling as an alternative to the Roth conversion, at least for some clients. We also note the following:

(1) The results were more favorable for married clients who can leverage the life insurance purchase with survivorship life insurance. Results were still favorable for a single female, but slightly less compelling for a single male.

(2) Increasing the anticipated rate of return improved the outcome of the Roth conversion over time.

(3) Similarly, increasing income tax rates incrementally narrowed the spreads between the two strategies.

(4) Conversely, increasing estate tax rates improved the result of the IRA Max because of the critical removal of the insurance proceeds from the client’s taxable estate.

(5) Finally, the IRA Max strategy still projected favorably for a younger client who had not reached RMD status.


We did not set out to establish flaws in the Roth conversion strategy or to show that one strategy is superior to the other. Our goal was to objectively compare the amount that could be transferred to the next generation under these different scenarios when both income and estate taxes are considered.

The takeaway is that clients should be made aware of all of their options when it comes to estate and financial planning. As insurance and financial services professionals, it is our responsibility to introduce the IRA Max and other planning strategies to our higher net worth clients for their additional consideration.

Richard A. Behrendt, J.D., is first vice president, senior estate planner, and Blake Panosh, is first vice president, insurance and annuity Manager, at Robert W. Baird & Co., Milwaukee, Wis. You may e-mail them at [email protected] and [email protected]


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