Overview of Part 1
The Roth IRA is the better-looking (and smarter!) cousin of the traditional IRA. The Roth IRA came into existence in 1997 as part of the Taxpayer Relief Act. The provision was named for Senator William Roth of Delaware.
Over the course of years since its adoption into law, much discussion has followed regarding the merits of converting a traditional IRA into a Roth IRA. The Roth IRA is particularly attractive for taxpayers with large IRA and qualified retirement plan balances. Frequently, wealth taxpayers really don’t need the money to live on and would prefer to defer taxation on investment earnings as long as they can.
This article is an introduction to how private placement life insurance (PPLI) can be used as an alternative to the Roth IRA. When we compare the attributes of PPLI to the Roth IRA, we will conclude that PPLI with some added “bells and whistles” is a superior alternative to the Roth IRA, hence earning the name the “Super Roth IRA¹”.
The Tax Landscape
Qualified plan assets and IRAs are very heavily taxed. These deferred income assets are subject to both income and estate taxation. In general, the combination of the two levels of taxation can erode 70-80 percent of the account balance depending upon which state you live in.
With the presidential election four weeks away, none of us has a crystal ball when it comes to tax policy. Absent any changes following the election in the “lame duck” Congressional Session, the bus is ready to drive off of the cliff.
Less I remind you, the Bush tax cuts are due to expire at the end of 2012. The top marginal income tax rate jumps to 39.6 percent. The new Medicare tax adds another 3.8 percent on unearned income. The phase out of personal exemptions and itemized miscellaneous deductions has the effect of adding another two percent. State taxation which can add another 5-10 percent. Taxpayers will be at a combined marginal income tax rate of 52-57 percent.
At the same time, the estate and gift tax exemption equivalent drops from $5.125 million to $1 million per taxpayer. The top marginal estate tax bracket increases to 55 percent from 35 percent.
As Congress can’t agree on anything, it seems unlikely that any last minute change will take place.
Roth IRA Basics
The Roth IRA allows for annual contributions of $5,000 ($6,000 if age 50 or older). A taxpayer that files jointly is able to contribute to a Roth IRA if the taxpayer’s modified adjusted gross income (AGI) does not exceed $173,000. The contribution phases out between $173,000-183,000.
For a single taxpayer, contributions phase out between $110,000-$125,000. A taxpayer that is married and files separately is unable to make a contribution if modified AGI exceeds $10,000.
The calculation of modified AGI excludes the proceeds from an IRA rollover or qualified plan. This important distinction generally speaking makes it easier for a taxpayer to position himself to do a conversion from a traditional IRA to a Roth IRA.
The tax rules for traditional IRAs require a taxpayer to begin required minimum distributions by April 1 in the year following the year in which the taxpayer reaches 70 ½. The IRS imposes a 50 percent excise tax on the difference between the required minimum distribution amount and the amount actually withdrawn. The distributions are taxed as ordinary income rates. Distributions before age 59 ½ are subject to a 10 percent early withdrawal penalty. The account balance is included in the taxpayer’s taxable estate.
The Roth IRA does not have required minimum distributions. Distributions are not subject to income taxation. However, the distribution must be a “qualified” distribution. Qualified distributions require five years of “seasoning” within the plan unless the taxpayer is at least age 59 ½.
Distributions before age 59 ½ are subject to the 10 percent early withdrawal penalty as well as normal tax treatment on the distribution (as if it were a traditional IRA). Exceptions to these rules exist for a distribution for a first-time home buyer; distribution to a disabled taxpayer, or a distribution to a beneficiary on account of the taxpayer’s death.
The account balance is included in the taxpayer’s taxable estate. At death, the remaining distribution of the account is subject to the same rules as the traditional IRA. A surviving spouse as the beneficiary of the Roth IRA can treat the Roth IRA as her own. Other beneficiaries must distribute the balance over their life expectancies.
The investment guidelines for a Roth IRA are similar to the restrictions for a traditional IRA. The policyholder can expand the investment guidelines through the use of a self-directed arrangement. The prohibited transaction guidelines applicable to the traditional IRA apply to the Roth IRA as well as the tax rules on unrelated business taxable income (UBTI)
In summary, the Roth IRA provides for tax-deferral and tax-free distributions without the requirement for minimum distributions during lifetime, but distributions over the lifetime of the beneficiary at death. The account balance is subject to estate taxation. Taxpayers are pretty limited on contribution levels as well as the amount of income they can have in order to qualify. Hence, many high net worth taxpayers will not qualify.
¹Super Roth IRA is a trademark of Reg Wilson of Epic Financial.
Whatever You Can Do, I Can Do Better!
The Super Roth IRA involves the taxpayer’s acquisition of a PPLI contract to use as a tax-advantaged wealth accumulation vehicle for retirement and wealth transfer purposes. Unlike the Roth IRA, the arrangement does not have investment restrictions and income qualifications.
PPLI is a customized variable universal life insurance policy that is institutionally priced. The policy is designed for accredited investors and qualified purchasers as designed under federal securities law. The customized investment menu may include registered funds, alternative funds, or a managed account structure.
Generally, the taxpayer would be the applicant, owner and beneficiary of the policy. In the event the policyholder is medically impaired an alternate insured can be substituted to prevent any adverse cost impact to the policy’s overall investment performance and efficiency.
Life insurance has many favorable tax attributes that are similar to the Roth IRA without all of the limitations of the Roth IRA. As a practical matter, life insurance may be the most tax-advantaged investment vehicle of any investment.
The inside buildup of the policy cash value is not subject to current taxation. The policyholder is able to take free withdrawals from the policy through loans or a partial surrender of the cash value. Life insurance has FIFO (First In, First Out) tax treatment. The policyholder is able to recover his cost basis (cumulative premiums) in the policy before being taxed.
Typically, a policyholder would recover his basis and then switch to low cost policy loans which receive tax-free treatment. The policyholder is generally able to borrow up to 90 percent of the policy’s cash value. The cost of a policy loan varies by life insurer. The range is 0-50 basis points per annum. The loan is non-recourse and can be repaid at death from the death proceeds.
The proceeds of life insurance of life insurance receive income-tax free treatment. The policy’s ownership can be arranged in a manner so that the policy proceeds escape estate taxation.
Unlike the Roth IRA, the Super Roth is not subject to income restrictions based on the taxpayer’s modified AGI.
Super Roth IRA Case Study
Joe Smith, age 50, is a partner with a large national law firm. Joe makes $2 million per year. He participates in the firm’s qualified retirement plan to the fullest extent possible. Following the demise of Dewey Lebouef, he is concerned with the long-term security of the firm’s non-qualified retirement plan for partners. As a result, he would like to set up a private retirement arrangement that will provide him with retirement plan-like benefits and tax treatment. The Roth IRA or traditional IRA are not considerations based upon his income level.
Joe’s wife, Mary, is the settlor of an irrevocable trust established in Delaware. The trustee, Bloomington Trust, is the applicant, owner, and beneficiary of a PPLI policy insuring Mary’s life. The trust is a discretionary trust. Joe and his wife both retain special powers of appointment over the trust. Joe is a discretionary income beneficiary of the trust long with his children.
The policy issued by Acme Life has annual premiums of $500,000 per year and a death benefit of $15 million, the minimum allowable death benefit under the tax law definition of life insurance, IRC Sec 7702 (guideline premium test/cash value corridor test). The policy investment options include several alternative investment options (hedge fund of funds; private equity), and a managed account managed by Joe’s investment advisor.
The policy is structured as a private split dollar arrangement between Joe and the trustee. The policy will be structured using the economic benefit method of split dollar. Each premium payment is not considered a gift, but rather, the economic value of the death benefit (term cost) is treated as an imputed gift to the trust. The imputed gift to the trust in Year 1 is $10,800. The projected imputed gift in Year 15 is $30,000.
At inception, the trustee collaterally assigns the policy to Joe who will have an interest in the policy cash value and death benefit equal to the greater of the cash value or premiums. The cash value is accessible during this time without restriction.
At age 65, Joe and the trustee decide to switch the split dollar method from the economic benefit to the loan method. The trustee will terminate the collateral assignment and instead provide a promissory note to Joe. The note provides for the accumulation of principal ($7.5 million) and interest at the long-term applicable federal rate at the time of the exchange. Hence, the loan will be repaid at death. Joe is subsequently able to sell the promissory note which is repayable at death at a discount to a family
The projected cash value is $20 million at age 65. The death benefit at that time is $30 million. The trustee’s distributions from policy loans and withdrawals receive income tax-free treatment for the trustee as well as Joe. The death benefit is income and estate tax-free. The policy under the trust’s spendthrift provisions is beyond the reach of personal and business creditors. The projected retirement benefit is $1.5 million per year – tax-free.
The Roth IRA is a useful planning device. However, the Super Roth IRA technique outlined in this article provides stronger tax benefits as well as investment flexibility. PPLI as a customized tax-advantaged and institutionally priced variable life insurance contract is the investment engine. The combination of tax advantages and institutional pricing allow the Super Roth IRA to provide excellent retirement income and estate planning benefits for high net worth taxpayers and their families. The Super Roth IRA fills in the wide gap left between the Roth IRA and traditional IRA for high income taxpayers.
Authors Note: The above article was written by Gerry Nowotny, a tax and estate planning attorney with a JD and LL.M in estate planning from the University of Miami School of Law.