Life Insurance, An Alternative to a Roth Conversion?

The tax law change that made conversions of traditional IRAs to Roth IRAs more widely available has been the buzz of the financial planning world since the new rule took effect at the beginning of 2010. For many clients, the income taxation triggered by the conversion of a traditional IRA to a Roth IRA is mitigated by the future tax-free growth of the converted Roth IRA. For other clients, however, the income tax bite on the Roth conversion may be too much to stomach, even if the income tax liability on Roth conversions in 2010 can be deferred into 2011 and 2012.

Is there an alternative planning opportunity for clients who are intrigued by the benefit of tax-free growth of a Roth conversion, but who ultimately reject the strategy because of the income tax liability triggered on the full IRA balance at conversion? One alternative strategy might be to use the required minimum distributions (RMDs) paid out on a traditional IRA to purchase life insurance. What makes this strategy worthy of consideration is the client’s ability to position the life insurance in an irrevocable life insurance trust (ILIT), which removes the insurance proceeds from the federal estate tax system.

Assumptions
In our test case, we considered a hypothetical married client with a $1 million current balance in a traditional IRA. The IRA is identified as a “leave on” asset (i.e., not needed for retirement expenses). We assumed the client and spouse are both currently 70 years old and are rated standard, non-smokers for purposes of life insurance underwriting. Based on the client’s RMDs scheduled to begin at approximately $27,000, we modeled in the purchase of a survivorship guaranteed universal life (SGUL) policy (with guarantees subject to the claims-paying ability of the insurer), requiring $27,000 annual premiums and paying a death benefit of $1.55 million at the survivor’s death. We also assumed that these are higher-net-worth clients with a combined estate large enough that the IRA will be subject to federal estate taxes, with or without the Roth conversion.

Comparing Results
We analyzed the net amount that would pass to the client’s heirs (after income and estate taxes) under three alternate scenarios: (1) traditional IRA with no changes, (2) Roth conversion, (3) traditional IRA beginning RMD to determine the amount of survivorship life insurance in an ILIT. (Assumes a rate of return of 6 percent.)

Caveats will include:

1. The results are more favorable for married clients who can leverage the life insurance purchase with survivorship life insurance. We will also summarize alternative scenarios for single male and females.

2. We will note that results will skew toward the Roth conversion if income tax rates are higher than the 30 percent rate assumed above.

3. We also will comment on the impact that a higher rate of return will have on these alternate options. Although a higher rate of return will increase the tax-free growth in the Roth IRA, it would also allow for the purchase of a larger death benefit.

In conclusion, using RMDs from a traditional IRA to purchase life insurance in an ILIT ought to be included as part of a discussion with higher net worth clients about the pros and cons of a Roth IRA conversion.