By Dennis Drake
Financial planning is a simple and focused process to meet a stated financial need or desire. In this case we're talking about Roth conversions. First off, why use a Roth? Let's agree that taxes are very likely to increase. The U.S. is a $21 trillion economy and we are $22 trillion in debt. It is predicted that we will be $40 trillion in debt by 2029. In addition, we have a whole host of issues that need to be dealt with, including Social Security, Medicare, Medicaid, interest on the debt, war and defense, healthcare reform, unemployment, healthcare cost, infrastructure, natural disasters, state and city budget shortfalls, derivatives, student loan crisis, black swan events, and more. Let's assume we agree that taxes must increase.
Federal income tax rates have been temporarily reduced in the recent tax reform act. This allows us to convert to a tax-free Roth IRA at a discount.
If you're married and filing jointly, you can earn up to $345,850 and still be in the 24% tax bracket. In 2017 this amount of income would have put you in the 33% tax bracket. As you can see taxes are currently "on sale."
Convert to a Roth IRA or Life Insurance?
Tax-savvy investors want to pay as little income tax as possible. Converting to a Roth IRA allows you to make smart tax moves that will save money in the long run.
Converting to a Roth IRA will guarantee that you will owe no additional income tax on the converted funds and any money those funds will earn before you withdraw them during retirement. The balance in your portfolio will be what you can tap in retirement, and you won't have to calculate an after-tax balance.
OK, so, we have a good argument on why we should do a Roth conversion on our qualified money, but why would we use life insurance as an alternative? And not just any life insurance policy will work well for this specific use. We need a type of policy specifically designed for this purpose. Life insurance policies are built differently, although in all cases the tax-free death benefit is the central focus and feature. The following is a list of reasons to consider a fixed-index universal life (IUL) insurance policy as a Roth IRA conversion alternative.
Self-completing death benefit: This is an insurance product, and ultimately, the thing you are insuring (your life) is of utmost importance. If you die too soon, this provision will help protect the ones you love.
Cash value: An IUL is a cash value life insurance policy. It allows you to access the cash value to use as you see fit at any time. With an IUL you can access your cash value at any age, without penalty or tax issues. You do not have to wait for some required age to access your cash value. Many tax-deferred retirement accounts have an age restriction of 59 1/2 before you can access the money. If you withdraw ahead of time, there are penalties and restrictions. With an IRA you do have some stipulations for emergencies and age distributions, but even so, an IRA can be limiting.
Zero tax: Distributions from the cash value of the life insurance policy are taxed the same as a Roth IRA but without the 5 year wait. Distributions can be made by withdrawals up to the cost basis or you can take a policy loan tax-free at any time for any reason.
Long-term care coverage: Many of these IUL policies also have provisions to help pay for long-term care costs. The cash value can be used to help pay for long-term care costs. In addition, some IUL policies offer long-term care insurance riders. With the rising costs associated with long-term care, having a hybrid policy might be a good option.
IUL policies provide protection against market downturns: Each year the gains are locked in or captured. So, every year your gain will be secured along with your previous cash value total.
An annual reset: This may not seem like much, but in reality, it's a really big deal. What it means is that you are always starting from zero every year and you never struggle to catch up due to previous market losses. Within an IUL your insurance company does not invest your cash value in the stock market. Instead, the life insurance company purchases options on the market index, providing the opportunity to make money when the stock market is up and helping avoid losing it when the market goes down.
No RMDs: There are also no required minimum distributions (RMDs) or penalties for early access. If you're converting to a Roth IRA you've eliminated your own personal RMDs, but not those that your non-spouse heirs would have to take. With an IUL, there are no RMDs regardless of who inherits it at your death.
Upside growth potential: The indexed universal life insurance policy has serious upside growth potential. If the market index that your policy is tracking increases 10% in a given year your account will be credited around 10%. If the market index increases 20%, your account will be credited with the maximum or cap, which is currently around 13% for most policies. When the index returns a rate that is higher than the cap, the life insurance company keeps the difference. Some of the newer policies also have un-capped accounts.
IULs don't impact Social Security: And, finally. IULs don't impact Social Security. Many people don't know this, but the benefits you receive from Social Security in retirement may be taxed as income if you make more than a certain amount. The income from an IRA might just put you over the limit ($32,000 if filing jointly, or $26,000 if filing as an individual in 2019) and therefore cause your Social Security to be taxable.
For example, say you get $24,000 a year from Social Security, and you take another $40,000 from your IRA each year. You may find yourself in a situation in which the Social Security benefits are taxable, and you'll end up in a higher tax bracket.
If, instead of an IRA, you had an IUL policy loan for $40,000 per year, your taxable income would be zero because you would be under the base limit. For an individual or family that is living on less than $80,000 per year, you may find that your annual tax savings are in excess of $10,000. For those making more, your savings would be even greater.
Let's address how this model works and the IRS guidelines around this model. Section 7702 of the IRS code defines what the federal government considers to be life insurance contracts and how they're taxed. Section 7702 imposes limitations on premiums and benefits relative to death benefits and defines what is considered life insurance for federal tax purposes. It applies to life insurance contracts issued after 1985.
Section 7702 was created to limit the tax benefits given to life insurance policies. It did this by defining what would be considered a life insurance policy, and investment vehicles that didn't fall under the insurance definition were not eligible for the favorable tax treatments.
What does this mean in English? It simply states that there are limits to how much you can put into a life insurance contract, based on the death benefit amount.
An important distinction here is that we are using the tax laws around cash value life insurance to grow and protect our cash to be used later tax free. The death benefit is an important part of this strategy, but what we are doing in essence is purchasing the minimum amount of death benefit allowed by law to create the most cash value as possible. We call that max-funding the cash value contract.
The indexed universal life policy is a solid and reliable life insurance product and an additional planning tool that provides a specific set of benefits to the consumer. For those who want a taste of the bull markets without the bite of the bears, this may be the perfect Roth alternative.
What Are the Cons?
Most IULs put a cap on the returns that can be earned: Insurance companies issuing this type of life insurance will often set a cap on the returns that you can earn from the index. For example, if the index grows by 14% and your cap is 12%, you get credited 12%. On the flip side if the index loses 14% your credited rate on most policies is zero. In this case, zero is your hero!
Some IULs set maximum participation rates: Insurers have the option with an IUL to set a maximum participation rate of less than 100% which could put a cap on the growth.
There are no guarantees with an IUL: If you're looking for a guaranteed return, then an IUL is not the right life insurance product for you. There are no guarantees available with this type of policy.
It isn't a 100% retirement solution: In no way, shape, or form would you put all your retirement dollars in this product. We would also use a traditional Roth conversion as a tax-free retirement tool in combination with the IUL.
Cost of insurance: The fees in a life insurance contract are front-loaded and can eat away at your cash value. Fees include the cost of insurance, policy fees, premium load, administrative, and surrender charges. These fees average between 0.13% and 1.2%, over time, which is very competitive compared to a typical brokerage account charging a 1% fee.
Age: You really wouldn't want to use this strategy prior to age 59.5. Converting to an IUL would subject you to the 10% early withdrawal penalty on your qualified plan. There is no penalty if you are doing a traditional Roth conversion.
A Word of Caution
Not all IUL policies are built the same and some have what I like to call "deal breakers" -- things like low company ratings, low caps on your growth potential, the indexes your growth is tied to, high cost of insurance, high cost internal fees, loan provisions including high rates and no cap on those rates, and more. Please don't let this scare you. A well-designed policy is an excellent choice for this Roth alternative model.
One more caveat: This model requires that you are insurable.
If this strategy sounds like a good alternative for your situation, please seek out the help from experienced professionals who deal with this strategy on a daily basis. The details matter.
About the author: Dennis Drake, LACP, is an Ed Slott Master Elite IRA Advisor and president of SMART Tax Free Retirement.