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(Presentations in this Blog were created using InsMark’s Wealthy and Wise® and the InsMark® Illustration System.)

Editor’s Note:  Blog #175 involves a revision to Blogs #150 and #152 to present some new material that should be helpful as you analyze the value of a Roth conversion for your clients.

The decision to convert an IRA to a Roth IRA is often waylaid by the client’s negative view of the income tax issues resulting from the conversion.  Let’s examine this concern because the income tax generated usually turns out to be a good investment.

The case study in this Blog involves a ten-year conversion of $600,000 in IRA funds to a Roth IRA with the goal of enhancing the retirement results for Robert and Ann Baxter.  Both are currently age 60 and planning to retire at age 70.  The results are significant as they can meet their annual, spendable, cash flow goal of $150,000 — indexed at 3.00% — while also providing an increase of $1,915,723 in their long-range net worth.  See below for a graphic of the results.

Image 1

Strategy 1: Status Quo – Keep the IRA

vs.

Strategy 2: Convert IRA to Roth IRA

This was accomplished without requiring any additional out-of-pocket cost to fund the income tax on the Roth conversion as its costs are covered using withdrawals from the Baxter’s taxable account.  (The $1,915,723 in increased long-range net worth is a pre-tax equivalent rate of return of 9.10% on the conversion’s income tax costs of $256,292.)

Below is a look at one of the newest graphics in Wealthy and Wise comparing the tax cost of keeping the IRA vs. converting it to a Roth.

Image 2

Strategy 1: Status Quo – Keep the IRA

vs.

Strategy 2: Convert IRA to Roth IRA

Inherited IRA vs. Inherited Roth IRA

There is another significant aspect to this analysis involving a potential inheritance alternative that Robert and Ann can provide for their child, Scott, currently age 30.

For this evaluation, let’s assume that Scott inherits either the IRA or the Roth at his age 65, 35 years hence.  Examine below the huge difference for Scott between an inherited IRA and an inherited Roth.

Image 3

Comparison of Inherited IRAs for Scott Baxter at Age 65

(Scott is currently age 30)

The Roth conversion not only adds $1,915,723 to Robert and Ann’s long-range net worth (see Image 1), it also adds an additional $9,626,121 ($11,114,702 minus $1,488,581) to their son’s after tax, retirement cash flow.  The $256,292 tax cost generated by Robert and Ann’s Roth conversion is not just a good investment as noted above — it is an astonishingly great one for the family!

Click here to review the reports for this comparison that confirm the numbers in Image 3.

The next time you have parents considering a Roth conversion, be sure to bring the issue of an inherited IRA vs. an inherited Roth to their attention as it is truly a showstopper.  The impact on heirs of an inherited Roth makes the original decision to convert to a Roth virtually irresistible.

Strategy 3

Strategy 3 is created by adding indexed universal life (IUL) with a face amount of $937,490 increasing for 10 years; level thereafter (and reduced in year 11 as much as possible while still avoiding MEC classification).  Premiums are $70,000 for 10 years.  Annual participating policy loans of $81,360 begin in year 11.

Click here to review the IUL illustration.

Strategy 3 policy values are next imported into Wealthy and Wise.  Below is the effect on the Baxters’ net worth.

Image 4

Strategy 1: Status Quo – Keep the IRA

vs.

Strategy 2: Convert IRA to Roth IRA

vs.

Strategy 3: Roth IRA + IUL

The IUL adds almost as much to long-range net worth ($1,849,543) as the Roth conversion ($1,915,723).  Overall, Strategy 3 increases long-range net worth to $10,305,956, a 57.56% increase of $3,765,266 over the status quo Strategy 1.  Both the tax cost of the Roth conversion and the premiums for the IUL are funded from assets, not from an out-of-pocket expenditure.

Conclusion

The coupling of a Roth conversion with IUL produces a formidable combination, and Wealthy and Wise provides a superb platform for the analysis.

Click here to review the entire Wealthy and Wise evaluation.

Licensing InsMark Systems

To license Wealthy and Wise and the InsMark Illustration System, visit us online or contact Julie Nayeri at Julien@insmark.com or 888-InsMark (467-6275).  Institutional inquiries should be directed to David Grant, Senior Vice President — Sales, at dag@insmark.com or (925) 543-0513.

Creating Similar Presentations

If you would like some help creating customized versions of the presentations in this Blog for your clients, watch the video below on how to download and use InsMark’s Digital Workbook Files.

Digital Workbook Files For This Blog

Before downloading and reviewing any files, be certain you have installed the most current updates to your Wealthy and Wise and InsMark Illustration System.  Do this using Live Update available under Help on the main menu bar of the System or this icon on the main menu bar: Note:  If you are viewing this on a cell phone or tablet, the downloaded Workbook file won’t launch in your InsMark Systems.  Please forward the Workbook where you can launch it on your PC where your InsMark System(s) are installed.

If you obtain the digital workbook for Blog #175, click here for a guide to its content.  It will be invaluable to you.

Testimonials

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Important Note #1:  The hypothetical values associated with this Blog assume the nonguaranteed values shown continue in all years.  This is not likely, and actual results may be more or less favorable.  Life insurance illustrations are not valid unless accompanied by a basic illustration from the issuing life insurance company.

Important Note #2:  The information in this Blog is for educational purposes only.  In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.

Important Note #3:  Many of you are rightly concerned about the potential tax bomb in life insurance that can accidentally be triggered by a careless policyowner when policy loans are present and net cash values are so low that the income tax on the gain on surrender (calculated using gross cash values less basis) is more – often significantly more – than the net cash surrender value.

This lurking tax bomb can be present in all forms of whole life and universal life where policy loans of any type are utilized.  It can be avoided, and you, the producer, are key to making sure your clients are aware of how to sidestep it.

A tax bomb can be avoided if the policy is neither surrendered nor allowed to lapse, since the policy death benefit wipes away the income tax liability.  The foundation of this special treatment is IRC Section 101.  This statute provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax.  This applies to the full death benefit, including any cash value component whether loans exist or not.

Can your clients remember these facts years into the future?  If they are incapacitated, will family members understand the issues?  It is probably best to file a short note with the policy – something like this (although your compliance officer will likely have preferred language):

If/when you take policy loans on this policy, be sure to talk to your financial adviser before surrendering or lapsing the policy in order to anticipate unexpected tax consequences that may otherwise be avoided.

Does this note make it harder or easier to deliver the policy?  It’s harder if you haven’t discussed it with your client; easier if you have.  And that’s the point – you should discuss it.

Some life insurance companies have concierge units that monitor loan status at the point of lapse or surrender, and you would be well-advised to select an insurance company with this capacity.  To be effective regarding the tax bomb, such carriers need to be proactive in their client relationships, not merely reactive to client inquiries.  I hope that ultimately the policyholder service division of all life insurance companies will bring this potential liability to the attention of those surrendering or lapsing policies, particularly those policies with 50% or more of the gross cash value subject to outstanding loans.