Evaluate a Roth Conversion as an Investment Opportunity
©1998 Peter James Lingane
Prepared for presentation May 14, 1998
North Bay Chapter, California Society of Enrolled Agents
The choice is clear when considering investing $2,000 after tax in a Roth IRA as compared to investing the same $2,000 after tax in a non deductible traditional IRA. Go with Roth because the earnings are taxable with the non deductible IRA. Simply put, the Roth IRA is the better investment.
When you pay the tax on a Roth conversion you are, in effect, moving funds from a pension or taxable account into Roth's tax exempt environment. A Roth conversion is often attractive, in part, because investing in your Roth IRA is better than your current investment alternatives.
Certain investments have a similar tax treatment as Roth when held to death. For example, life insurance death proceeds are not subject to income tax. So, one alternative to investing money in your Roth IRA might be to purchase life insurance, especially variable universal life insurance (VUL) where the death value is based on the performance of the underlying mutual funds. Capital assets like stocks and bonds and homes receive a "stepped up valuation" at death. If you were to purchase stock in a taxable account and hold the stock until death, your heirs would pay no income tax on this investment.
Roth accounts, death proceeds and capital assets are all subject to estate tax.
Although earnings on a Roth IRA, on VUL death benefits and on a "buy and hold till death" investment portfolio can all be tax exempt, investing in Roth is the most profitable choice. Variable universal life is burdened by the mortality and expense (M&E) charges and buy and hold is burdened by the current taxes paid on the dividend stream.
Comparing the latter two alternatives, investing buy and hold can provide similar returns to VUL. If there is a lot of turnover, what I facetiously "buy and churn," variable universal life is significantly better.
These conclusions are based on a simple fact set. A 62 year old couple have a million dollar traditional IRA and $400,000 cash. The IRA and cash are surplus to the couple's needs and would never be invaded for economic reasons. The required distributions from the traditional IRA begin at age 71 using an initial life joint expectancy of 22.4 years which is not recalculated. The couple have no need for life insurance.
The three alternatives are therefore
Each alternative provides a total annual return of 10 percent after the usual investment expenses. Extra M&E charges reduce the effective return for VUL to 9%. The income tax rate is 40% before death, the estate tax rate is 50% and the effective post death income tax rate on the Traditional IRA is 20% (net of the Schedule A deduction for the estate tax paid at the second death.) Net distributions after income tax are re-invested in the buy and hold portfolio.
Twenty five years later at age 87, the assumed age of the second death, the Roth account has grown to $10.8 million, the variable universal life policy has grown to $3.4 million, the buy and hold portfolio has grown to $3.6 million and the side fund created from the IRA distributions is worth $4.6 million. These accounts are free of any income tax liability.
The traditional IRA is worth $2.6 million before income tax.
After paying estate taxes on all the account and paying income tax on the traditional IRA, and adding the pieces, the cash distributions to the heirs are $5.4, $5.1 and $5.2 million respectively for the Roth, VUL and buy and hold alternatives. Investing in a Roth conversion is the most profitable investment.
This analysis neglects the post death benefits that accrue to the traditional and Roth IRA accounts. For a variety of reasons, Roth accounts enjoys slightly better post death tax treatment than does a traditional IRA. The Roth account is also larger than the traditional IRA account. Therefore, the relative advantage of Roth will widen post death.
If the return of the buy and hold portfolio were taxed currently, cash distributions to the heirs would be $5.4, $4.6 and $3.7 million respectively. Variable universal life policy can be superior to buy and churn.
The analysis and conclusions are summarized in the following table.
Roth Conversion Variable Universal Life Buy and Hold Strategy under consideration Create a $1 MM Roth IRA by paying $400,000 in income tax Use the $400,000 to purchase VUL and keep the $1 MM Traditional IRA Invest the $400,000 and keep the $1 MM Traditional IRA Limits on Contributions No contribution is allowed if income is above $100,000. Contributions are further limited by the size of the IRA Underwriters may impose policy limits due to poor heath or absent a clear need for large amounts of insurance Unlimited Earnings Tax deferred until five years and 59½ Tax exempt thereafter Tax deferred until w/d or annuitized Tax liability is forgiven at death Dividends and STCG taxed currently LTCG are tax deferred and the tax liability is forgiven at death Early Withdrawal sharply reduces benefits Tax penalties before age 59½ and for withdrawals from 1998 conversions Earnings are taxed but basis is recovered first Tax penalties before age 59½, except for annuities and tax free loans Withdrawals and annuities are taxable with earnings taxed first No tax penalties and withdrawals may be taxed as LTCG. There may be limited control over basis by selling specific tax lots Loans No Yes, but a default could trigger tax Investment loans may be deductible Portfolio Changes Unlimited without tax implications Unlimited without tax implications Trading triggers tax except §1031 Special Costs, beyond investment management fees Nominal custodial fee at some institutions 1% extra mortality and expense costs Justified if there is a need to create an estate or to provide liquidity at death Holding costs like management and accounting fees Heirs/IRA Balance (Buy&Churn) $5.4 million $5.4 million $5.1 million $4.6 million $5.2 million $3.7 million _________________________________ This summary is not a complete discussion of the issues nor is it a full recitation of state and federal tax laws and regulations. Investment returns, tax rates and mortality and expense ratios are for illustration only and may not be representative of actual policies or of future results. Review your personal circumstances with your advisers before contributing or converting to a Roth IRA.