Advisors: Consider the Split Annuity/Roth Conversion Strategy

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 “outside” of 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.