In 2010, the former $100,000 AGI limit to convert an IRA to a Roth IRA was permanently repealed. No matter their age or income, anyone with an IRA has the option to convert it to a tax-free Roth IRA, at any time, as long as the income taxes on the conversion are paid.
Often, younger taxpayers in their 30’s or 40’s who have not yet accrued large balances in a traditional IRA are tempted to make the taxable conversion. This is because all future growth and future normal retirement distributions from the Roth IRA will be tax-free. Younger clients with 401(k) accounts who “separate from service” of their employers may choose to transfer the 401(k) funds to a traditional IRA and then convert this IRA to a Roth IRA.
Older and wealthier clients in their 60’s or 70’s with large IRA balances may be looking for ways to efficiently finance the payment of large income taxes due upon a conversion from their IRA to a Roth IRA. This requirement to pay the income taxes in the same year as the conversion takes place is a major stumbling block, and often, wealthier IRA owners with large balance IRAs will keep their IRA and not take any action.
Is there a method where a Roth IRA conversion can be financed and allow clients to achieve the dream of unlimited tax-free income for their family over an extended period? The answer is yes, and life insurance provides the key to unlocking the golden door to a tax-free future for a surviving spouse and family.
Basic Roth IRA Conversion Rules
- The former $100,000 AGI limit to convert an IRA to Roth has been permanently repealed.
- For those that wish to convert an IRA to a Roth IRA, 100% of the income tax due upon conversion is due in the same tax year as the conversion takes place.
- Part or all of a traditional IRA may be converted into a Roth IRA. For retirement planning purposes, individuals may wish to keep part of the IRA in an IRA and convert only part of their funds into a Roth IRA for more extended estate planning purposes.
Step-by-Step Procedure for a Married Couple to Achieve a Tax-Free Conversion
- IRA owner names spouse as IRA beneficiary. The owner must take required minimum distributions (RMD) from the IRA upon reaching age 70 ½ until death.
- IRA owner buys a no-lapse Universal Life (UL) policy on his/her life and names the spouse as beneficiary of the policy. If desired, the IRA owner may allocate any after-tax RMDs for premium payment.
- At the death of the IRA owner, the surviving spouse first executes an IRA to IRA spousal rollover. This rollover is accomplished with no tax consequences.
- Then, the surviving spouse converts all or part of the spousal rollover IRA into a Roth IRA. The spouse names the children/grandchildren or trusts as the beneficiary of the new Roth IRA account(s) for their benefit.
- The spouse receives the life insurance death proceeds income tax-free. The proceeds paid to the spouse qualify for the federal estate tax marital deduction.
- The spouse uses all or part of the tax-free insurance death benefit to pay the income taxes on the Roth IRA conversion.
- The spouse is now the owner of a Roth IRA and, if needed, may take tax-free distributions from the account. There are no required distributions while the spouse is alive.
- At the spouse’s subsequent death, the balance of the Roth IRA is included in the gross estate. With proper planning, a no lapse SUL survivorship life policy owned by an ILIT could have been purchased and allocated while both spouses were alive to offset any second death estate taxes.
- The beneficiaries of the Roth IRA (children/grandchildren or trusts for their benefit) have two distribution choices to receive the “inherited Roth IRA”.
- Choice #1 is the so-called “5-year rule” … that is, the Roth IRA account must be completely distributed within five years after the death of the IRA owner.
- Choice #2 is the “life expectancy rule” … that is, the account can be paid out annually over the life expectancy of the beneficiary using the Single Life Table factor if RMDs start no later than December 31st of the year after the death of the Roth IRA owner. When a trust is the beneficiary of the Roth IRA, the trust beneficiary with the shortest life expectancy will be the measuring life for annual RMD distributions to that trust. The trustee will then distribute tax-free Roth IRA distributions to the trust beneficiaries each year, and issue trust K-1 to report the tax free income.
The 3 Phases of IRA and Roth IRA Account Management
Phase #1 During the lifetime of the IRA owner, RMDs are distributed according to the Uniform Lifetime Table
Phase #2 At the death of the IRA owner, the surviving spouse completes the Roth IRA conversion process (see conversion sequence above) using the life insurance proceeds to pay income taxes due upon the conversion. No RMDs from the Roth IRA are required for the remaining lifetime of the spouse.
Phase #3 Roth IRA beneficiaries receive income tax-free distributions either according to the “5-year rule” or the “life expectancy rule”. If the life expectancy method is chosen, the Single Life Table will determine the length of the tax-free RMD payout based on the life expectancy of the beneficiary. Children could easily have a life expectancy of 25 to 35 years, and grandchildren could easily have a life expectancy of 50 to 70 years depending on the facts of the case. 100% of the “inherited Roth IRA” RMDs over that extended period will be INCOME TAX-FREE!!
BSMG can provide competitive annuity products to fund both regular IRAs and converted Roth IRAs. Moreover, BSMG can provide access to many of the top no lapse UL and no-lapse SUL carriers to efficiently finance the payment of income taxes and/or estate taxes. The tax-free financial leverage of using life insurance to finance the Roth IRA conversion plan will enhance the net after-tax inheritance for your client’s family.
Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group