The Roth Conversion Alternative

Since its inception in 1997, the Roth IRA has been a powerful tool for assisting in creating tax-free income for retirement. Despite low contribution limits and phase outs for those with AGI above certain thresholds, the ability to convert to a Roth IRA is open to anyone. Strategically converting portions of your qualified assets (i.e., a traditional IRA) to a Roth IRA can significantly enhance your future retirement outlook by:

• Insulating your retirement against tax increases
• Lowering taxes on other taxable assets
• Lowering taxes on social security income (Roth distributions do not count as provisional income)

However, converting to a Roth comes with a loathsome truth: you owe taxes on that converted amount. You have a couple choices to pay the tax:

1. Withhold the taxes directly from the IRA you are converting
2. Pay the taxes from the Roth you have just converted to (with a major caveat)
3. Pay the taxes out of other assets or cash flow

Most people opt for number 1. This is understandable, as most people don’t have extra cash lying around that they are happy to send to the IRS for taxes. Even if they do, it causes ulcers to think about. This is why many people tend to shy away (unfortunately) from Roth conversions. I say “unfortunately” because this is an emotional, not mathematical, decision-making process. If you can check your emotions and let the math guide, it’s easy to see the benefits over time.

The Nonsense

Still, many have the perspective that if they pay taxes on the conversion from the IRA they have converted (or partially converted), they now have gone “backwards” and have to make up that difference. The perception is “I’ve lost ground.” I’ve even read some say it can take a decade to “make up” that difference. 

Nonsense. 

This is a false perspective, especially if the conversion did not jump you to a new tax-bracket. There is nothing to make up. See, you owe the tax. Now or later, you owe it. It might be sitting in your account, but it

does not belong to you. You have not lost anything by paying the IRS their share now and forever forward having a tax-free nest egg, nor have you lost “future gains” you would have earned on the taxes paid. 

Proof

Here’s the proof:

Let’s say you have a 25% effective tax-rate and an IRA balance of $100,000. You are 60 years old and don’t plan on using it until age 70. For simplicity’s sake, we will assume you convert the IRA all at once (this is often done in stages).
What do you notice? Obviously, I’ve tried to make it clear. In simple terms, they look equal. The net after-tax balance of the traditional IRA (your share) is equal to the tax-free Roth balance. What about income from each?

Let’s say at age 70 you want to take out 5% per year.

IRA Balance at age 70: $196,715

5% income: $9,835.75

Taxes (25%): $2,458.94

Net income: $7,376.81

Roth IRA Balance at age 70: $147,536

5% income: $7,376.81

So, did it cost you anything to convert? No. Are you really going backwards? No, because the taxes you paid upon converting (so long as you managed the tax brackets properly) aren’t really part of your account balance. That money doesn’t belong to you. The IRS is allowing you to hold it for them because they know taxes are likely to increase in the future. That wouldn’t make this a tie, it would make the IRS win, even if taxes went up by just 1%.

For those who still hold on to the fallacious argument that they will somehow be in a lower tax-bracket upon retirement, I have no words. I mean, have you seen our national debt? Social security and medicare solvency issues? The political landscape?

Is There a Winner?

Still, you might be wondering if it’s worth it since it seems like a tie here (from this simplified example). Small secret that’s not really a secret–it’s not a tie.

I assumed an effective tax rate in all years of 25%. But, say at age 80, you wanted to lump out your traditional IRA (why, I couldn’t tell you, but it happens). The balance is $386,968. Can you have that income and still only pay 25% in tax, and net the balance shown of $290,226? 

Not a chance. You’ll pay way more with all that income, and net way less. But you could lump out the Roth IRA and have that tax-free balance. I still ask “why?” but the point is you could. Tax-free. No Uncle Sam.

Further, income (including RMDs) from the IRA causes taxes on social security. Income from a Roth IRA does not. This is a big part of the calculus that many people, including advisors and CPAs, miss. Imagine having to pay taxes on up to 85% of your social security because of your IRA or 401K, and at your highest marginal tax rate. That's just how it works.

Roth IRAs (and LIRPs, for that matter) do not do this. So, it’s not equal, even if it looks like it. The fact is, the Roth conversion here likely saved you thousands in other taxes indirectly that the traditional IRA would have caused. 

Can you pay the taxes from the Roth that you just converted to? Yes, as long as you are over 59 ½ so that the early withdrawal penalty won’t smack you. Basically, if you convert under 59 ½, the converted amount still has a 5-year rule before using that amount without causing the early withdrawal penalty. This 5-year rule does not apply to conversions if you’re over 59 ½. You can use that converted amount immediately, including to pay the taxes due.

What if I’m Under 59 ½?

Ok, great. So withholding taxes on a conversion isn’t really going backwards, it’s just paying the IRS what you owe them and legally divorcing them from that time forward.  

What about if you’re under 59 ½ and want to convert. A little stickier, but not if you’re thinking. Here, you cannot withhold the taxes from your traditional IRA because that counts as a distribution…and you’re under 59 ½. So, you would owe the regular taxes plus that nasty 10% early withdrawal penalty.

That is not good. That is going backwards. 

Work around?

You can always pay the taxes out of cash or income. Feels kinda like getting a black eye from a snickers bar, but it does work. But what if you don’t have money lying around that you’re anxious to send to the IRS, no matter the future benefits of the Roth conversion? 

It could make sense to utilize a 72t distribution and contribute that amount to a Roth IRA. Here, we take a small departure from conversion to contribution, but the net effect can be the same. A 72t distribution is an underutilized but highly effective way to distribute money from a Traditional IRA under 59 ½ without paying that pesky early withdrawal penalty. It’s an involved formula to figure out what amount your 72t would be, but software or your IRA custodian easily helps with this. 

For example, assume you have a traditional IRA and are 55 years old. You’d like to convert to a Roth IRA but want to avoid the penalties that would be caused if you withheld taxes directly from the conversion. So, you enact a 72t distribution from your IRA. Here’s the rub: whatever the distribution amount is, you must continue that same distribution for 5 years or until age 59 ½, whichever is longer. This is called “Substantially Equal Periodic Payments” (SEPPs). 

Let’s assume your SEPP is $12,000. Now, this is a distribution, not a conversion, so you can withhold the tax without any issues. Say you net 9k after tax withholding. You can now contribute that to Roth IRAs (the max is $7,500 for those over 50 in 2023 so hopefully a spousal Roth IRA exists in your situation for the overage).

The net result is the same as a Roth Conversion, if on a smaller scale. If the 72t exceeds your ability to contribute to a Roth IRA ($15,000 between husband and wife Roth IRAs if you are over 50), considering a properly structured Life Insurance Retirement Plan (LIRP) may be appropriate in your situation. A LIRP technically has no contribution limit (or they are exceedingly large limits). 

Again, if you’re fine paying the taxes on a conversion out of cash holdings, you don’t have to go this route with a 72t if you’re under 59 ½. 

But is there something altogether potentially better?

Roth Conversion Alternative

What about having your cake and eating it, too? What if you could “convert” to a tax-free environment and still have the money you would have paid in taxes working for you? This would be gaining ground upon the conversion, wouldn’t it?

This is precisely what a LIRP (Life Insurance Retirement Plan) Conversion can potentially accomplish with the right setup. But first, we have to review the way an index/participating loan works within a LIRP/IUL. 

You may borrow money against the LIRP’s cash value to pay the taxes. The advantage is that the money you normally would have withheld to pay the taxes in a Roth Conversion is still inside the LIRP with the ability to earn a positive return above the borrowing rate. This is called arbitrage, and can make a large difference in the future projected balances and income potential for you. This is also a powerful way to use the LIRP for supplement retirement income down the road.

Example

Let’s consider an example:

You are 60 years old. 

You have a traditional IRA of $250,000. 

You have an effective tax rate of 20%. 

You’d like to convert $50,000 per year until it is all converted, withholding 20% directly from the conversion. The net converted amount is therefore $40,000 per year ($50,000 - 20% = $40,000). 

You want to take maximum distributions at age 75 through age 90. 

Let’s also use historical returns of the S&P 500 for the past 31 years and assume a 1% management fee. 

The conversion schedule, the historical returns, would look something like this:

After the 7th year, the IRA would be completely converted and all taxes paid from the conversions directly. Cool. All gains and distributions are tax-free from here forward (assuming compliance with the 5-year rule). 

But what if we didn’t have to lose the value of those tax amounts being withheld? What if we could borrow the taxes owed, get the benefit of the full account value for future gains, and increase our future potential tax-free distributions?

That scenario is possible with a properly structured LIRP, and might look like this:

The taxes are still paid, but your converted balance in the LIRP is much higher than the Roth due to not losing the taxes from the account, but rather borrowing against the LIRP from the insurance company to pay the taxes, giving yourself a higher base to earn more money on from future gains. Yes, there is a cost to that borrowing against the policy, but all that is taken into account in the below analysis. 

Other positive characteristics of the LIRP to consider: 

• 0% floor against market losses
• Locking in of gains earned either every year
• Tax-free access under age 59 ½ without penalty
• Ability to borrow from the policy, not reducing your account value, and still having the potential to make gains on the full account value.

Generally speaking, those advantages are not had in Roth IRAs…but I really do love Roth IRAs. Anything that gives tax-free growth and distributions, I’m into. 

So, how does this shake out in the end? 

Using the market returns from Jan 1, 1992 (including dividends reinvested) and a 1% management fee, the Roth IRA produces $64,157/yr from age 75 through 90. 

Cool.

What about the LIRP?

Let’s handicap it a bit and create a proxy asset to stand in place of the LIRP as I add stress to it, just to prove a point. Starting back on Jan 1, 1992, we’ll use the simulated values of the S&P Prism index, one of the indexes available in this LIRP. 

Also, we’ll increase the annual fees of the LIRP by 15% per year. This creates over $13,000 of additional expenses that don’t actually exist on the insurance illustration. 

In the 11th year, the policy has a 0.57% persistency credit from that time forward. It’s a nice jolt in the arm to enhance the earnings that many LIRPs offer. I discounted that to 0.4%, resulting in more than $10,000 lost gains as well as any compounded gains on that lost amount. 

This showcases the power of not reducing the account balance to pay the taxes, but instead keeping the account balance intact and borrowing against the LIRP to pay the taxes. The proxy simulation of the LIRP shows more than $644,000 of additional tax-free distributions above the Roth IRA. On an annual basis, this is over 35% more income than the Roth IRA.

How about ending balance?

Roth IRA: 0

LIRP Proxy: ~$131,483, plus an insurance death benefit above this. 

What about gross rate of return comparisons? Using a simple average:

Roth IRA: 12.15%

LIRP Proxy: 8.64%

Having that higher account balance in the LIRP by borrowing the taxes instead of withholding them adds a huge advantage. Had I not handicapped the LIRP proxy simulation (adding fees that don’t exist in the current illustration and decreasing the persistency credit in year 11), the differences would be even starker, but I’m ok being conservative. 

What About the Fees?

I am often asked about the fees associated with a LIRP. Many naysayers hang on to this objection as a trump card in the analysis. I don’t fault them for it because this is a poignant fact that needs to be addressed. Still, the analysis above is net of all fees. So, one way to answer the fee question is to point out that the Roth IRA, in this case, produced $644,000 less income and had $131,483 less account value at the end, making it over $775,000 more expensive from that perspective. 

Let me answer it in a more traditional manner. What is the total value annual average fee expense ratio of the LIRP proxy, remembering that I inflated the fees 15% above what they actually are for the sake of adding stress?

Answer: 0.23%

I dare anyone to tell me that is an expensive fee ratio. 

When structured and used properly, LIRPs are not expensive. They are, in fact, highly competitive in their output and what they charge for that output. 

A final point to consider on this topic is what the fees are actually paying. In traditional portfolio management, such as was assumed in the Roth IRA, it pays for…well, management. Account statements. Online access. Hopefully someone to answer your calls. 

In a LIRP, those fees instead pay for a term insurance death benefit, guarantees against market losses, locking in of annual gains, and the ability to use that term insurance death benefit for long-term care if needed. In other words, it pays for useful stuff. You can pay for one or the other, but the point is that LIRPs often are about the same cost as anything else. 

Conclusion

Of course, a well-rounded retirement strategy should have many asset classes with differing strategies. As a Roth conversion alternative, the LIRP offers some attractive advantages that deserve consideration.