As the Baby Boom generation ages, advisors increasingly will be working with clients in the distribution stage of their portfolios. Advising on IRA distributions can be more challenging than advising on accumulation.

If clients save substantial amounts, invest in a well-diversified portfolio, and focus on tax-advantaged accounts, accumulation success may be obtained. Portfolio drawdown, however, can be handled in multiple ways. pdf

CHANGE OF DIRECTION

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Recent events are affecting distribution planning. For years, advisors had anticipated adoption of the Department of Labor’s fiduciary rule, which may have led to conservative strategies.

Now the DOL rule has been banished. Some advisors, therefore, are pursuing aggressive distribution strategies that they might not have considered.

Unfortunately, some of the suggested remedies will figuratively leave clients cast away on Gilligan’s Island without the level-headed Professor. Three years into the deal, the sponsors may be gone and clients will be on their own.

Among these potentially aggressive strategies are “IRA rescue” arrangements. The underlying idea is that traditional IRAs and other tax-deferred plans need to be rescued because withdrawals could be heavily taxed.

A common solution is to move money from IRAs, pay tax, and use the net amounts to buy life insurance. The policy’s death benefit will be free of income tax, in most cases, while cash value policies also may deliver tax-free growth and tax-free income for the owner’s retirement.

For example, I represent a couple who bought life insurance on the wife, who is younger and qualifies for a lower premium. This happened before they asked me for advice.

Their plan called for them to take large distributions from the husband’s traditional IRA over three years, putting the money into life insurance. The cash value was low and the death benefit was extremely high. (The high death benefit increased the agent’s commission.)

After three years, the insurance would go from an increasing to a level death benefit. The policy would have more cash value and a lower death benefit.

At this point the husband’s traditional IRA will be virtually stripped, so taxable RMDs wouldn’t be a future issue. The plan was to borrow money from the policy, tax-free, and use those dollars to pay the tax on the IRA withdrawals. 

According to the policy illustration, the anticipated cash value would grow substantially, without being subject to income tax. The clients could take additional tax-free loans, if money was needed, or leave the policy alone to provide a tax-free death benefit to the beneficiaries.

PRICEY AND PROBLEMATIC

Used correctly, life insurance often can play a valuable role. However, I was alarmed when I looked closely at this plan.

The agent’s commission and other costs weren’t disclosed. I calculated that total expenses went well into six figures, over 50% of the first-year premium!

In addition, an IRS examination of this transaction might conclude that my clients owned a modified endowment contract (MEC), rather than a life insurance policy. If so, supposedly tax-free policy loans could be subject to income tax. In the proposal, the idea of the contract being recast as a MEC, with adverse tax consequences, wasn’t mentioned.

Yet another issue is that a life insurance policy illustration may show compound cash value growth beyond reasonable expectations. Lower cash value growth could produce a poor outcome, and the structure of this deal left no practical way to save the policy. 

THE ROTH RATIONALE

Other approaches to IRA distribution planning can be safer and potentially more profitable. I often suggest that clients use Roth IRAs.

Suppose that Jack and Rita Smith have a total of $800,000 in their traditional IRAs. Their taxable income is around $200,000 a year.

With current tax rates, the Smiths annually could convert $80,000 of their traditional IRAs to Roth IRAs and stay in the 24% tax bracket. They would owe $19,200 a year in federal income tax on these conversions, which they can afford to pay with non-IRA dollars.

After 10 years of such conversions, this couple would empty their traditional IRAs and avoid further RMDs. Their IRA money would be on the Roth side, where they can invest in a portfolio that matches their risk tolerance and return goals.

After five years and age 59-1/2, Roth IRA owners can withdraw any amount, free of income tax. This could help the Smiths enjoy a comfortable, low-taxed retirement.

Among their options, Jack and Rita could use tax-free Roth IRA distributions to buy life insurance, payable to their children or grandchildren. This would ensure a substantial legacy to loved ones, income tax-free.

Interested clients could choose a life insurance policy with a guaranteed death benefit. The policy also might provide lifetime cash for treatment of a chronic illness or long-term care, if necessary.

CANCELING THE CONTRACT

In the situation I mentioned, where the client went into an IRA rescue plan, I discovered what had occurred when the insurance policy could still be canceled. Following my advice, the client canceled the policy and put the money withdrawn from the traditional IRA into a Roth IRA. 

We expect to use a Roth IRA investment and distribution plan, including the purchase of a desirable life insurance policy. This plan is likely to be less costly, less taxing, and possibly more rewarding than the original IRA rescue plan.  

The client situation mentioned in this article, where a couple agreed to an IRA rescue plan, is by no means unique. Some life insurance agents and some advisors are pursuing possibly questionable strategies, now that the hesitancy caused by the DOL fiduciary rule has subsided. 

Thus, advisors might be approached by insurance agents who are advocating such IRA rescue routes. Or, clients might announce that they already have taken such a step, perhaps on the advice of another advisor.

In order to serve retirees and clients who are approaching retirement, it’s vital to be aware of the questionable plans being circulated. You should be prepared to review such proposals and provide a realistic appraisal.

I believe that the road to H*** may be paved with bad IRA distributions. By taking the time to evaluate too-good-to-be-true proposals and suggesting lower-risk alternatives, you can put your clients on a better path.

Advisor action plan:

  • Discuss distribution planning, including IRA withdrawals, with retired clients and those who will soon leave the workforce.
  • Go over conventional ideas such as the 4% Rule and Bucket Plans, to see if some variations might be suitable.
  • Mention that some questionable strategies are arising, especially those using life insurance for investment purposes.
  • Offer to go over any proposals clients are considering, including any that involve insurance products.
  • Explain the benefits of Roth IRAs, such as possible tax-free distributions of investment income and the lack of required minimum distributions.
  • Suggest to selected clients that traditional IRAs might be converted to Roth IRAs, especially with the reduced income tax rates now in effect.
  • Develop an effective long-term investment plan for the resulting Roth IRAs.
  • If life insurance is desired for estate planning, indicate that the premiums might be paid with money from tax-free Roth IRA distributions.