Benefits of the Piecemeal Internal Roth Conversion (PIRC)
The following content is adapted from the book Tax-Free Income for Life by David McKnight.
In my last article, I discussed the advantages of the fixed indexed annuity (FIA). I also shared two significant disadvantages: tax rate risk and Social Security taxation. Now, I want to look at a potential option for combatting these two risks, which can help you to align your tax-free stars.
To combat the effects of higher taxes and Social Security taxation, most insurance companies allow investors to convert their fixed indexed annuity to a Roth IRA prior to electing their guaranteed lifetime income. In theory, this solves two problems. First, a tax-free guaranteed lifetime annuity is immune to tax rate risk. Never at any point would you have to spend down your stock market assets to compensate for rising tax rates. Second, because distributions from Roth IRAs do not count as provisional income, you are perfectly positioned to receive your Social Security 100 percent tax-free.
But sadly, not all is as rosy as it seems. While all insurance companies allow for a Roth conversion within the FIA itself, the vast majority of these companies require that the conversion be undertaken all in one year.
Aligning Your Tax-Free Stars: An Example Scenario
To illustrate the disastrous consequences of this insurance company requirement, consider the following example. Let’s assume you had a $1 million FIA held within your IRA. Let’s also assume you needed $100,000 of pretax income to meet your lifestyle needs in retirement. You recognize the implications of tax rate risk and Social Security taxation and want to shift your money to tax-free. The insurance company gives you permission to convert your FIA to a Roth IRA, so long as you convert the full $1 million in one year. To understand how this could impact you, I’d like you to think back to that long, skinny cylinder from your high school chemistry class. That’s right, a graduated cylinder.
Well, the tax system in our country works exactly like that graduated cylinder. When you distribute money from your IRA, either to spend or to convert to a Roth IRA, that income goes into your tax cylinder and flows all the way down to the bottom. Some of your money gets taxed at 10 percent, some at 12 percent, some at 22, 24, 32, 35, and 37 percent.
If you converted your entire $1 million IRA in one year, all of that income would flow into your tax cylinder and land right on top of your lifestyle income. That means your total gross income for the year would be $1.1 million! When you account for both state and federal tax, that could push your effective tax rate as high as 40 percent. So what, exactly, have you done? In an effort to avoid a doubling of tax rates over time, you doubled your tax rates in the short term!
A Better Way
Some forward-thinking insurance companies (only four at the time of this writing) have provisions that allow for something that’s altogether revolutionary in the world of tax-free retirement planning. Instead of requiring you to convert your entire IRA in one year, they allow for what I call a piecemeal internal Roth conversion (PIRC). In other words, they grant you the flexibility of converting your IRA in any amount, over whatever time period you deem appropriate.
What’s more, they give you two options for paying the tax on those piecemeal conversions. The first option is to pay the tax out of your 10 percent free withdrawals every year. This would allow you to pay the tax without incurring any surrender charges from the insurance company. The second option is to pay the tax out of a separate investment account in either your taxable or tax-deferred bucket. If you have enough money in your taxable bucket to pay the tax, this is by far the superior approach. You preserve 100 percent of the assets in your most tax-efficient bucket (tax-free) and spend down the assets in your least tax-efficient bucket (taxable) along the way. This approach allows you to preserve 100 percent of the tax-free, inflation-adjusted guaranteed lifetime income you’ll eventually draw from your FIA. Talk about aligning your tax-free stars!
Now that we know that the PIRC is an option, consider another example. Let’s assume it’s 2020 and you had that same $1 million FIA within your IRA along with the $100,000 pretax lifestyle need from the previous example. Let’s also assume you’ve postponed Social Security until after the Roth conversion period is over. We can further assume that given your financial situation, you want to convert the entire annuity to a Roth IRA before the 2018 tax cuts expire in 2026 and tax rates go up. Finally, we’ll assume that the underlying FIA accumulation account averages 3 percent net of fees over the Roth conversion period. Given all this information, you’d need to convert roughly $218,000 per year from the IRA inside your fixed indexed annuity to a Roth IRA over that five-year period.
There are two major benefits of following this course. First, given your ability to spread the taxes out over five years, you would pay taxes on those conversions primarily in the 22 percent and 24 percent tax brackets. This would save you massive amounts of taxes over the all-in-one-year Roth conversion required by most annuity companies. Second, by completing the conversion within that five-year time frame, you’ll finish paying those taxes before the tax sale ends in 2026. Once 2026 rolls around, that 22 percent tax bracket becomes 25 percent, and the 24 percent tax bracket becomes 28 percent. And as we move past 2026 to 2028, 2030, and beyond, tax rates will have to rise even higher to keep our country out of bankruptcy.
If punitive, all-in-one-year Roth conversion features are any indication, most insurance companies have put very little thought into the implications of tax rate risk. By requiring that Roth conversions be executed all in one year, they exacerbate the tax consequences the conversion was calculated to avoid. Fortunately, a few proactive insurance companies recognize what’s at stake and have allowed for piecemeal internal Roth conversions. This allows you to spread your tax liability over multiple years in an effort to maximize your after-tax income in retirement.
By paying less tax during your conversion period, you can maximize your tax-free income and receive your Social Security 100 percent tax-free. As a result, you won’t be forced to spend down your stock market portfolio to compensate for all that additional taxation. That means you’ll have much more money to pay for discretionary expenses later in retirement.
At Hanson, We Can Help
If you’d like to learn which insurance companies offer this PIRC option, or discuss how to guarantee your own tax-free income for life and you have not yet implemented a strategic plan with Hanson Wealth Management, I hope you’ll reach out for a consultation. The approach we use to plan your secure retirement includes lowering your tax burden and optimizing your income streams with the objective of achieving a tax-free retirement so you can truly live your best life. I look forward to hearing from you!