Slashing taxes on IRAs, Pt. 3Article added by Michael Reese on April 29, 2009
Michael Reese

Michael Reese

Traverse City , MI

Joined: August 21, 2010

In my last two articles, I introduced you to Joe. As you'll recall, Joe is retiring with a $1 million 401(k) plan balance and he is interviewing different financial planners before he lets Fidelity wrap up his money in an IRA transfer. We've been taking the approach of focusing on the taxation of his retirement plan instead of arguing how our investment is better than what Fidelity offers. In this way, we've been able to set ourselves apart.

We learned in part one that if Joe and his wife continue down the road they are travelling, just by taking the required minimum distributions, Joe and his wife will be forced to withdraw more than $1.8 million. Their children would inherit a bit more than $1.4 million, so the IRS gets to collect tax on $3.2 million of distributions. As a result, the IRS collects approximately $1 million on Joe's $1 million IRA.

In part two, we learned that through a Roth conversion, Joe and his family were able to save taxes on roughly $2 million. In other words, instead of paying tax on $3.2 million, Joe and his family pay tax on roughly $1.2 million. The concept here was nothing more than moving money from a tax-deferred bucket (a qualified retirement plan) to a tax-free bucket (a Roth IRA). Joe did not have to do this all at one time. In fact, we assumed that he made this transition throughout a nine-year period.

The problem with our analysis was that it did not create a scenario where Joe needed you. After all, couldn't he simply stay at Fidelity in the Roth conversion through them? And if he did that, how does that help you? This approach could potentially be a win-lose, meaning Joe wins but you lose. We are looking for solution that would be a win-win.

So how do we create a win-win? We do it by providing a solution that Joe cannot come to on his own. We've learned that moving money from a tax-deferred bucket to the tax-free bucket created a big win for Joe. But is a Roth IRA the only option in the tax-free bucket? The answer, of course, is no. We have two other options in the tax-free bucket to choose from that may provide benefit for Joe and his family -- municipal bonds and properly designed life insurance.

Given the interest rate that municipal bonds are paying, they do not provide a good solution. Properly designed life insurance, on the other hand, particularly indexed life insurance, may provide a very attractive solution. This graph compares Joe's current planning, a Roth conversion and life insurance.

From the charts you see that both the Roth conversion and life insurance provide a significant benefit to Joe and his family above and beyond the tax savings. You'll notice that in the early years life insurance represents the optimum solution, but in the later years the Roth option becomes the best. So how do we know which option is best for our client? Obviously, if Joe could tell us when he's going to die we can help him pick the best option. But clearly, that is not something we can predict.

There is one feature that the life insurance brings to the table that we all need to be aware of, and that is that many companies now provide free long term care insurance as part of a life insurance program. What does this mean for Joe and his family? It means they take the life insurance option and then Joe will have additional long term care protection they didn't have before. If Joe should need long term care prior to his death, the life insurance option would provide more funds than the other two. This benefit alone is often enough to make the life insurance alternative the optimum choice at all age points.

An additional benefit of the life insurance is that it does not have to cover only Joe. You may choose to cover both Joe and his wife. When you cover the wife, who is usually a little younger and a little healthier, you find that you push the line that represents the life insurance option up. Why is this? Because women tend to have lower costs of insurance than men due to their longer life expectancies. The impact of these lower insurance costs is that the insurance is more efficient and thus provide better numbers.

But do you need to make a choice of all of one or all of the other here? Of course not. For example, you could choose to convert half of the IRA to a Roth IRA and move the other half into life insurance over time. This graph illustrates the results of this approach.

Here we find what may turn out to be the optimal solution for Joe and his family. The combination of some Roth conversion and some life insurance provides a benefit line that is significantly better than Joe's current position at every age. Joe and his family up saving tax on roughly $2 million and clearly those tax savings end up in Joe and his family's pocket.

In summary, by engaging Joe in a discussion of the tax impact of his retirement plan and his options in significantly reducing that taxation for the benefit of himself and his family, we've been able to set ourselves apart from our competition. In addition, we've been able to have a discussion with Joe in an area that Fidelity cannot help him. The likelihood that Joe becomes a new client becomes very high, as we are able to deliver benefits that no one else is able to do.
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