Avoiding taxes on Roth IRA conversions sales platform: Fact or fiction?Article added by Roccy DeFrancesco on February 11, 2010
Roccy Defrancesco

Roccy DeFrancesco

MI

Joined: May 24, 2006

I believe that Roth IRA conversions are one of the most overhyped and misused concepts in the financial services industry today. Because at least one IMO/FMO is out there marketing the plan discussed below, I wrote this cautionary article to give you my opinion on this "magic" plan.

Avoiding taxes on Roth IRA conversions? Really? No, there is no way to legally avoid taxes when converting your IRA. When I saw this marketing plan, I knew it was not a no-tax solution.

Borrowing money to pay the Roth IRA conversion taxes. When I heard about the plan discussed below, I knew it had to involve leverage (borrowing money to pay the tax upon conversion).

Investing in fractional life settlements (FLS). What really shocked me about the program I reviewed is that it seemed to be a FLS sales platform (versus a FIA sales platform).

Why would an advisor be interested in selling FLSs? Because the commission paid on money invested is approximately 7 percent (and an IMO can make an override of 1 percent to 2 percent.)

The program I reviewed has several different conversion scenarios. Due to space constraints and the fact that this plan doesn't interest me in the slightest from a suitability point of view for any clients I'd work with, I'm just going to give you an overview of one of them. If this program interests you (and I hope it doesn't), let me know, and I'll refer you to someone who can get you more information.

One iteration of the plan assumes that a client has the money to pay the taxes upon converting to a Roth IRA. The client would take the money he/she would have used to pay the taxes and invests it in FLS. When I learned about the plan, I was told that advisors should tell clients the typical FLS return over time is 10 percent and that it should mature on average in eight to nine years, depending on the type of FLS purchased.

The client is given a line of credit to pay the taxes due upon conversion and the interest due on the loan and then waits for the FLS investment to pay off. If the interest on the loan is lower than the net after tax return from the FLS when they pay off, the client wins the game.

Potential problems:

No. 1: The main problem is that FLSs might not pay off timely or provide a high enough return to fully pay back the loan and the rolled-up interest.

No. 2: This structure, even if it works, does not generate enough of a return to pay all of the taxes due upon conversion. If it performs as planned, it can generate returns to pay back the loan and provide a modest rate of return for the client.

I was told the loan rate can be as high as 7 percent in the current environment of extremely low interest rates. I also do not believe (although I couldn't verify it) that the loan interest rate is fixed.

Let's just look at an example of one version of this plan. A client who is in the 35 percent income tax bracket has $500,000 in an IRA and is looking to convert. The taxes due on conversion are $175,000. He takes his own $175,000 and invests it in FLSs. He then takes out a line of credit at 7 percent to pay the $175,000 tax and rolls up the interest on the loan. He then waits for someone to die so his FLS will pay off the loan and the interest can be paid back.

Let's assume the FLS investment pays off in eight years, and the return for the client is 10 percent.
  • Loan balance with rolled-up interest in eight years = $300,683

  • Return on the FLS investment = $375,108 (gross amount)
After paying taxes on the return, he would have a net amount left after paying back the loan and interest of $45,108.

By the way, if the FLS only returns 5 percent because it took 12 years for the person whose life insurance policy was purchased to die, the client would owe the lender $100,075.

What does a client think of this kind of plan? I can hear the conversation:

Client: So, you want me to borrow money and roll up the interest, use the borrowed funds to pay taxes on the Roth IRA conversion, use the money I normally would have used to pay the taxes to invest in an FLS, and then hope someone dies so I can pay off the loan and have some money left over?

Advisor: Yep!

Client: Have you got a screw loose?

More FLS sales

To me, this platform looks like it was constructed simply to sell FLSs, not to bring a conservative tax-mitigation plan to a client. In my example, if the client buys into this structure, I'm assuming the selling advisor will give a sales pitch as to why the above client should put his entire $500,000 IRA balance into FLS, as well. The agent would make out very well: $675,000 x 7 percent = $47,250; and the IMO pushing this can make its 1 percent to 2 percent override.

Other variations

One of the other variations of this has the client borrowing money from his/her home to pay the conversion tax and then to invest the money inside the Roth IRA into FLSs. Could it work out to a client's benefit? It might (or not).

Summary

There is nothing wrong per se with an accredited investor investing in FLS. However, borrowing money in a Roth IRA conversion structure to invest in FLS is too risky for me to recommend it as a viable structure. Could it work? It could. Could the client lose money and be worse off after implementing the plan? Yes. Do you want your clients borrowing significant money and then sitting around waiting for people to die so they can get out of debt and, hopefully, make a couple of bucks at the end of the rainbow? That's for you to decide.

To me, this is a greed-based platform that will be sold to clients in the best possible light so maximum sales/commissions can be made by agents and marketing organizations.

Could I have spun this article to make this concept sound great, refer hundreds of agents to an IMO/FMO, and make significant money myself on overrides? Absolutely. Instead, however, I've given you my honest opinion as I always try to so you can decide for yourself if this is something you should look into further.

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