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Using Indexed UL to Fund the Conversion of an IRA to a Roth IRA

Traditional IRAs offer clients a great opportunity to accumulate assets for retirement. IRAs allow for pre-tax contributions to an account where assets grow tax-free until the participant takes distributions. But traditional IRAs also have disadvantages for participants. IRAs are subject to minimum required distribution rules. Participants must begin taking taxable distributions at age 70½, whether or not such distributions are wanted or needed.

Clients who have traditional IRAs may be forced to take distributions when they do not need them. This makes it harder for clients to grow the amount of assets they can pass on to their children after death. When traditional IRAs are inherited after the participant’s death, the assets are treated as income in respect of a decedent (IRD). Distributions from the IRA are still subject to income taxes.

Consequently, IRAs are not the asset that most family members want to inherit. Distributions from an IRA are subject to income taxes, even when inherited. Unlike many other assets, IRAs do not get a step-up in basis upon the owner’s death. This means for your clients’ heirs, the face value of an IRA is not the value they will receive. In other words, inheriting an IRA is like inheriting a house that has a mortgage.

One solution to these problems is to convert a traditional IRA into a Roth IRA. A Roth IRA enjoys the same benefits of tax-free growth as a traditional IRA, but distributions from a Roth IRA are income tax-free. So, inheriting a Roth IRA is like inheriting a house with a prepaid mortgage.

There is, however, a cost associated with this type of conversion. Tax law allows an IRA owner to convert all or part of the IRA into a Roth IRA. But, in order to do so, the IRA owner needs to satisfy two conditions:

  • The owner's adjusted gross income (AGI) on the federal income tax return must be less than $100,000 (not including the amount of the Roth IRA conversion) in the year the conversion takes place.
  • The IRA owner must report the portion of the IRA converted as ordinary income and pay state and federal income taxes accordingly. For optimal financial results, it is recommended that the taxes be paid from funds outside the Roth IRA. In this way, income tax advantages of tax-free growth and tax-free distributions of the Roth IRA can be maximized.

New tax law signed into effect on May 17, 2006 eliminates the AGI limitation for conversions taking place after 2009 (see Recent Developments below). Beginning in 2010, the AGI limitation will no longer present a barrier to individuals considering a Roth conversion.

But many IRA owners avoid making a Roth IRA conversion simply because they do not want to use outside funds to pay income taxes. Or, maybe they do not have the funds needed outside of their IRA to pay the tax cost of conversion. For these IRA owners, a strategy is needed to identify a source of funds that would make a Roth conversion possible.

Here are some questions for financial professionals to consider:

  • Do you have clients who will be leaving significant qualified retirement plans or IRAs as an inheritance for family members?
  • Would these clients prefer to pay the income taxes on their traditional IRA balance in order to pass on an income tax-free source of income to their heirs?
  • Do these clients believe the use of funds to pay taxes on an IRA conversion is efficient relative to other possible uses for those funds?
  • If you could provide your clients with a source of funds, would they be more likely to convert their traditional IRAs to Roth IRAs?

Steps to Funding the Conversion with Life Insurance

Below is a step-by-step look at how life insurance can be used to fund the conversion:

  1. The IRA owner names his or her spouse as the IRA beneficiary.
  2. The IRA owner purchases a life insurance policy to pay the tax costs of converting to a Roth IRA after the owner's death. The owner's spouse is named as the beneficiary of the life insurance policy.
  3. The IRA owner pays the policy premiums annually. This may be accomplished by taking taxable withdrawals from the IRA.
  4. At the IRA owner's death, the surviving spouse rolls the IRA over into his or her name and elects to convert the account to a Roth IRA.
  5. The spouse receives the life insurance death benefits and uses them to pay the income taxes resulting from the Roth IRA conversion.
  6. The spouse takes distributions from the Roth IRA as needed and names the children as beneficiaries.
  7. At the spouse's death, the children receive the balance of the Roth IRA income tax-free.