As 2010 approaches, advisors wonder if the numbers make sense for their clients to convert to a Roth IRA. This may be an opportunity to establish tax-free income for your clients, paying only the current income tax now at the time of conversion and passing the remainder of their Roth account to their beneficiaries at death.
Clients who want to leave a legacy but do not feel like writing a check to the IRS can consider another option: Fund a life insurance policy now with the income from their IRA assets – combined with an income stream they will not outlive.
A 65-year-old married client has an IRA currently valued at $500,000, invested in a long-term bond paying 6 percent per year. Let’s also assume the couple lives to age 95. The $30,000 of annual income generated by the IRA is equivalent to approximately $20,000 after-tax when federal and state taxes are taken into account. The couple (both aged 65 and in good health) could use the net proceeds from the IRA ($20,000) for 10 years to buy a paid-up Guaranteed Universal Life (GUL) policy with an $860,000 death benefit payable upon the passing of the second spouse.
Of course, there will be minimum distribution requirements from the IRA beginning at age 70 ½, but at the end of the 10-year period the IRA would still be worth approximately $500,000.
Beginning at age 75, the client could continue to draw their RMD amount from the IRA account each year, or any amount they need to spend (with the understanding that RMD amounts as a percentage of the IRA assets start relatively small and grow larger as the client gets older). The risk of outliving the IRA assets remains a concern if expenses are large early on, or if the client lives longer than expected.
In order to equalize the income payments throughout retirement, they could use the $500,000 IRA balance in year 10 (at age 75) and purchase an income annuity that would guarantee about $45,000 per year of income (equivalent to a withdrawal rate of 9 percent) for the remainder of their joint lives. The risk of this arrangement is that if both spouses pass away before 11 years of income have been collected, they could lose money on the annuity strategy.
An alternative to the joint annuity would be a joint annuity with an “installment refund” provision. This provision allows for a continuation of payments to the beneficiaries until the entire original $500,000 has been paid out. Of course, the annual payment on this annuity is slightly less ($44,000 per year versus $45,000), but the risk of not getting the original investment back is removed from the scenario.
Assume the client allows the IRA to grow at 6 percent until age 75, and then starts drawing the income from the account at 6 percent a year. This would provide a pre-tax annual income of about $50,000. At age 95, the beneficiaries would receive about $580,000 from the IRA after-tax. This number could be lower if estate tax or state inheritance tax comes into play.
If the client instead spends the IRA income in the first 10 years and purchases a joint life insurance policy, and then purchases an income annuity, the annual income would be slightly lower, but the $860,000 life insurance payout would be both estate- and income-tax free.
A final strategy note – in order to effectively remove the value of the insurance proceeds from the client’s estate, the policy should be purchased within an irrevocable trust, and the trust should be the owner of the policy. The $20,000 annual premiums should be gifted to the trust for the purpose of funding the insurance policy. This technique also provides creditor protection against the insurance proceeds.
Benefits of this strategy – the income annuity offers a lifetime income without the worry of outliving the assets, while at the same time allowing for more accurate planning for risks like high healthcare costs, creditors and lawsuits. The $860,000 of insurance proceeds (held outside of the estate) would be the after-tax equivalent of leaving behind a $2 million IRA account to a high tax-bracket individual – after estate and individual taxes are taken into consideration. This number could be even higher if your state imposes an inheritance tax.
Mark A. Cortazzo, CFP is senior partner with MACRO Consulting Group in Parsippany, N.J.