Close Close

Portfolio > Economy & Markets > Fixed Income

Advisors: Consider the Split Annuity/Roth Conversion Strategy

Your article was successfully shared with the contacts you provided.

Many of your clients may decide to make changes to their retirement blueprint, either as they approach retirement or as the result of the economy. Many may have accumulated a great deal of money in their IRA, 401(k) or other retirement plan.

The money in their accounts may have grown substantially due to the duel benefits of tax-deductible contributions and tax-deferred growth. Congress provided them with these advantages as a way to encourage them to save for their retirement. However, as is often the case with tax legislation, advantages that seemingly save them taxes may one day be offset by taxes that they could ultimately be required to pay.

There may be a way, utilizing the split annuity/Roth conversion strategy, to significantly reduce future taxes that they and their heirs will likely be force to pay.

By taking advantage of the tax breaks provided in their IRA, 401(k), 403(b) or other tax-qualified retirement plan your clients accomplished two things: They accumulated a great deal of money, but they also accumulated a fairly large future tax liability.

The IRS will not allow them to defer paying taxes on this money forever. That is why they strictly enforce the minimum distribution requirements that force them to start making taxable withdrawals at age 70-and-a-half.

Some of your clients are in the fortunate position of not needing income from their IRA or other retirement plans to support their retirement lifestyle. Many of your clients would just as soon not touch this money, leave it in their IRA and not pay the taxes. But they can’t. They must start taking at least the minimum distribution amount at the required time. Considering what their IRA or other plan could have grown to (if they had not been required to take any distributions), these IRS-forced minimum distributions might erode their IRA’s principal down by 50 percent or more over their projected life expectancy. And remember that every penny they were forced to withdraw will be subject to income taxes.

Any remaining balance will one day be passed on to their heirsand so is the tax burden. The beneficiaries might defer these remaining taxes by stretching out minimum IRA distributions over their lifetime (often referred to as a Stretch IRA). However, even when “stretching,” the inherited IRA results in the balance growing over future years, which means the ultimate tax liability grows as wella burden that one day may present a tax legacy for the heirs.

Some clients are fortunate enough to have other assets that they don’t need income from their IRAs. But what about less fortunate clients who are counting on their IRAs to provide the supplemental income they know they will need throughout their retirement? Their income needs might force them to withdraw greater amounts then the IRS-forced minimum distributions and thus increase the amount subject to current taxes. Over the years many of these people will see their IRA balances decline significantly because they will need to increase withdrawals by an amount necessary to pay the taxes. But…

  • What if there were a plan that didn’t require them to take minimum distributions, unless that was their choice?
  • What if there were a plan that allowed them to receive any distributions they choose to take 100 percent tax free?
  • What if there was a plan that passed any remaining balance on to their heirs, also 100 percent income tax free?

The solution

Fortunately there is. It’s the Roth IRA.

Many people are familiar with the advantages of the Roth IRA. They already know that the Roth IRA allows wealth to accumulate and ultimately be distributed entirely free from income taxes. Yet many people have chosen not to convert to a Roth IRA.

Their reasoning “appears” to be clear enough. It is that current income taxes must be paid on the amount converted. For many people this “conversion tax” can seem to offset the tax advantages of converting to a Roth IRA. Is the conversion tax a valid reason not to convert to a Roth? Let’s do a little math to help answer this important question.

Assume that we have an individual with $300,000 in a traditional IRA. To make the example simple we are going to assume that it grows at precisely 10 percent each year (I just like to use easy numbers; change the numbers if you like). Further, we will assume that she is taxed at the rate of 33 percent.

At 10 percent, her $300,000 IRA account will generate an annual income of $30,000. Because all of the income withdrawn from a traditional IRA is fully taxable, the $30,000 would be reduced by 10,000 by taxes (due to her 33 percent tax rate). The IRA’s net after-tax income would be only $20,000. In other words, she has a spendable income of $20,000 from her IRA.

In addition, let’s say that she also has $100,000 invested in an account that is outsideof her IRA. Again, to make the example simple we will assume that this money also is credited with a 10 percent rate of return. She has many additional assets, but for the purpose of this illustration we will only concern ourselves with these two assets.

At 10 percent, the $100,000 in the account outside of her IRA will generate an additional income of $10,000. Again, taxes would reduce this amount down to only $6,700. So, she has an additional spendable income of $6,700.

Let’s compare this to an alternate portfolio that includes converting the $300,000 traditional IRA to a tax-free Roth IRA. 

Now when the $300,000 in her newly converted Roth IRA generates the annual income of $30,000, the total tax due would be zero. She has $30,000 of spendable income compared to only $26,700 of spendable income prior to the Roth conversion.

A bitter pill to swallow? Maybe not.

This conversion does require the payment of $100,000 in current income taxesan amount equal to the balance of the account that is outside her IRA. Using this entire account to pay the conversion tax may appear to be bitter pill to swallow but let’s look at what effect this would have on her after-tax, spendable income.

She no longer has any income from the account that was outside the IRA (because that was used to pay the conversion tax). However, she has $30,000 of spendable income compared to only $26,700 of spendable income prior to the Roth conversion.

And, the additional spendable income isn’t the only advantage she gains. An added benefit of converting to a Roth IRA is that one day her heirs will receive any remaining balance 100 percent free of income taxes. Instead of the potential tax legacy that can accompany the inheritance of a regular IRA, her heirs receive the Roth IRA balance with absolutely no requirement to share even a penny of the money with the IRS.

Many of your clients are already familiar with these Roth IRA benefits. Yet, no matter how attractive the resulting tax advantages, they view the potentially large conversion tax as being entirely unmanageable. This is precisely why the split annuity/Roth conversion strategy may be more attractive to these clients.

The use of this strategy can effectively reduce the conversion tax down to a more affordable amount, and still allow the IRA owner and his or her heirs to ultimately enjoy the many advantages of a Roth IRA.

To illustrate this concept, let’s consider another hypothetical IRA owner who is age 65. She has an adjusted gross income of less than $100,000; she pays tax at the rate of 28 percent; and has a total of $100,000 in her IRA. Currently, she doesn’t need any additional income. However, beginning at age 70-and-a-half she plans to start taking withdrawals from her IRA. While future income is important to her, she would also like to know that there may be some money left in her IRA so that one day it could be passed on to her heirs.

At first she decides against converting when she learns that a tax of $28,000 will be due if she converts her entire $100,000 IRA to a Roth IRA. In her mind, this is simply too big of a price to pay to gain the advantages of the Roth IRA.

Split annuity/Roth conversion strategy

Fortunately, she learns about the split annuity/Roth conversion strategy.

She discovers how she can use this strategy so that the conversion tax becomes a much more manageable amount of $10,149. How does she do it?

She splits the $100,000 that is in her IRA into two parts. Let’s refer to these parts as two pools of money. In one pool she places a total of $63,755. The remaining $36,245 is placed into the second pool.

Instead of a $28,000 tax, in her 28 percent tax bracket, she would pay a much more affordable $10,149. The next step in this strategy (after the Roth conversion) would be to place the $36,245 that is in the new Roth bucket into an indexed annuity. It’s like any other fixed annuity you may be familiar with, but with one basic difference—the way the gains are credited. Instead of crediting a company-declared interest rate of say 4 percent, 5 percent or 6 percent, the gains are linked or indexed directly to the performance of a leading market index.

Like other fixed annuities, your client has a 100 percent guarantee of principal plus interest. They cannot lose a penny as long as they stay in the contract for the full contract term. However, they also have the potential to earn money if the index goes up. It is planned that no withdrawals would be made from this Roth IRA (equity indexed annuity or EIA) pool for a period of 15 years (from age 65 when she first utilized the split annuity/Roth conversion strategy to age 80). All of the withdrawals received by the owner during this period would come from the single premium deferred annuity (SPDA) that was in the regular IRA pool. By not taking distributions from the Roth IRA (EIA) pool for 15 years the balance would be allowed to benefit from compound growth.

Assuming a hypothetical growth rate of 7 percent, the Roth/EIA bucket would have a balance of $100,000 by the end of 15 years (again, when the client in our example is age 80).

So, she started with an IRA that had a balance of $100,000. She utilized the split annuity/Roth conversion strategy and divided this $100,000, placing one part into the SPDA pool (which stayed in the original IRA) and the second part into a Roth IRA (EIA) pool. After 15 years the entire amount of the regular IRA pool was distributed to her (totaling $93,120), and now (15 years later at his age 80) the Roth IRA (EIA) pool has grown to $100,000. Instead of $100,000 in a regular IRA (with its IRS-forced minimum distribution requirements and 100 percent taxation), now she has $100,000 in a Roth IRA that is 100 percent income tax free (based on current law), and with no distribution requirements.

The owner can take any amount of distributions that she wants or can choose to never take a distribution. It is entirely up to her. Not a penny of income taxes will be paid on any amount she might take. And, consider that at her death any amount remaining in her Roth IRA bucket will go to her beneficiaries income-tax free.

The split annuity/Roth conversion strategy allowed her to escape the IRS-forced minimum distributions after age 80, and allowed her and her heirs to receive all further distributions 100 percent free from income taxes. Plus, it reduced her conversion tax to an amount that she could much more comfortably accept.

For many people, income taxes can be a roadblock that prevents them from accomplishing objectives important to themselves and those they love. These are people who often share similar retirement goals:

  • They want to reduce any unnecessary income taxes.
  • They want to increase their monthly income while preserving their principal.
  • They want to make certain that they will never lose money.
  • And, above all else, they want to be sure that they never run out of money.

A well-structured plan using the split annuity/Roth conversion strategy can help your client achieve peace of mind and the retirement security they deserve.

See also:


© 2023 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.