Annuity Illustrations
Annuity Marketing, Sales Ideas, Suitability, and Issues by Michael J. Prestwich

The conventional wisdom when doing a Roth IRA conversion in 2010 is to advise your clients to take Congress’ generous offer and wait to pay half the tax in the 2011 tax year and the other half in the 2012. However, it will be better for many of your clients to attribute the income to the 2010 tax year because of the tax increases that start in 2011:

·         the 10% tax bracket sunsets. This means that those filing Joint tax returns will pay 15% instead of 10% on the first $17,200 of income ($8,600 Single), an $840 tax increase.

·         the marriage penalty will return. Taxpayers who file a Joint return will pay 25% on $29,050 of their income instead of 15%. This is a $2,905 increase for Joint tax payers with Adjusted Gross Incomes of $174,800 or more.

·         the 31% income tax bracket will be replaced by 33% and the 35% tax bracket has been replaced by 39.6%.

·         If HR 3200 becomes law, add a 1% surcharge to the 31% tax bracket, a 2% surcharge to the 39.6% tax bracket, and a 4.4% surcharge on income that exceeds $1,000,000 – that’s 44%.

So what does this mean in dollar and cents terms?  Here are the tax calculations for a $1,000,000 Roth IRA conversion for a retired married couple, filing a joint return, who have an Adjusted Gross Income of $250,000 and itemized deductions of $50,000:

2010 Taxes Without Roth IRA Conversion: $41,811

2010 Taxes With $1,000,000 Roth IRA Conversion:  $386,848

Roth IRA Conversion Cost: $345,037

2011 Taxes Without Roth IRA Conversion: $43,484

2011 Taxes With $500,000 Roth IRA Conversion:  $241,716

2012 Taxes Without Roth IRA Conversion: $43,173

2012 Taxes With $500,000 Roth IRA Conversion:  $240,280

Roth IRA Conversion Cost: $395,339

In this situation, your client would save over $50,000 in Federal Income Taxes by attributing the $1,000,000 income from the Roth IRA Conversion to 2010 instead of $500,000 in 2011 and 2012. Clients who have lower incomes and/or smaller rollovers may find that splitting the income between 2011 and 2012 is ideal, but in this situation, this is clearly not the case.

Take home message: Before making a Roth IRA Conversion recommendation, first calculate the income tax ramifications for your client.

�

In 2010 thousands of retirees will get conned by misinformed or unscrupulous salespeople who will talk them into an unsuitable Roth IRA conversion. If you want to become one of those people who, like Bernie Madoff, make themselves rich at the expense of their unsuspecting clients, here is a step-by-step guide:

1)    Use a Roth IRA Conversion calculator similar to the one offered by CalcXML.  This calculator is perfect, because it leaves no trace; your name does not appear, nor does the name of your client. Throw away the second page to avoid embarrassing questions about your input.

2)    Use a lower tax bracket in the pre-retirement, “accumulation” years than the post-retirement, “distribution” years.  This printout uses 25% and 33%.

3)    Since this client does not have $250,000 of ready cash to pay the taxes for the conversion, use “Option 2,” where the taxes are painlessly paid from the existing IRA funds.

4)    Sell a product that has a 25% premium bonus and explain that the bonus will cover the income taxes.

Informed financial professionals can instantly see problems with the above scenario:

1)    Ethical financial professionals never use calculators that omit their contact information, the client’s name, assumptions used, pertinent disclosures, and includes a sentence about seeking the advice of an income tax professional.

2)    A Roth IRA Conversion calculator that uses “Tax Bracket” fields can be manipulated to deceive the client as I did in the sample printout. As a minimum it should have an input for “Adjusted Gross Income” and use the income tax rates that President Obama proposed for 2010 and beyond.  Nobody who has $500,000 added to their income in a single year is in a 25% tax bracket!

3)    The software should take all income tax ramifications into account.  The sample printout does not take into account the fact that the client is age 56, and would incur an additional $25,000 tax penalty (10% early withdrawal penalty).

4)    Taking into account both of above mentioned potential tax issues, the income tax impact for this client is about $250,000 higher than what was disclosed!

5)    Products with premium bonuses may help offset current income taxes, however, a premium bonus is never “free.”  There is always a cost somewhere, often in the form of lower interest rates.

I recommend the following safeguards to protect consumers from tax penalties and financial institutions and their representatives from potential lawsuits:

1)    Insurance companies, marketing organizations, and broker / dealers should train their representatives about a how a Roth IRA conversion will affect a client’s current and future income tax situation, and how to determine whether it is suitable for their client.

2)    Insurance agents and registered representatives should insist that a licensed income tax professional review the tax calculations and assumptions of Roth IRA conversions over $100,000.  This may save the client tens of thousands of dollars in taxes, and a tax professional’s endorsement may shield against a future lawsuit.

3)    File a complaint with the appropriate supervising authority against any insurance agent or securities representative who uses the above unethical approach to Roth IRA conversions. 

4)    Financial institutions should review all calculations and reports, including the tax professional’s review, before implementing a Roth IRA conversion.

In Sunday’s “60 Minutes” interview President Obama shot down the House’s proposed 90% tax bracket on bonuses from employees of companies who receive bail out money by saying,

“As a general proposition, you don’t want to be passing laws that are just targeting a handful of individuals. You want to pass laws that have some broad applicability … you certainly don’t want to use the tax code to punish people.”

Notice that he did not condemn the concept of a 90% tax bracket. Obama has proposed a tax increase that increases the current 35% top tax bracket to 39.6%. If President Obama follows Franklin Delano Roosevelt’s lead, these tax increases may be only the beginning of a new wave of income tax increases. In 1932, and again in 1936, when faced by budget deficits caused by the Great Depression, FDR increased the top tax bracket from 25% to 79% (Source: IRS Website).

When helping clients plan their future income, annuity producers should discuss the possible income tax effect of this income, and whether annuities can help reduce these taxes.  Annuities can help your clients in the following ways:

1)    Taxes on interest can be deferred to a time when the client is in a lower tax bracket

2)    SPIA (Single Premium Immediate Annuities) that are funded with non-qualified money can produce income that includes a tax-free return of principal

3)    Although all the income from Lifetime Income Riders is 100% taxable, even from non-qualified money, those who desire a guaranteed lifetime income can lock in a high, fixed interest rate for the rest of their life

If history repeats itself, and Congress raises taxes back to the 90% tax bracket for unearned income (meaning, non-wage income), annuities have the potential of causing your clients to pay massive future taxes. Explain to your clients the problem that they may have if they defer the taxes until they die, when all the accrued interest becomes payable in a lump sum. If they want to leave their heirs a tax-free lump sum at death they perhaps should purchase a life insurance product instead of an annuity.

The point is that “taxes” is a hot topic right now, and is the perfect door-opener to tell your story to your clients, prospective clients, and their income tax advisors.

• Married, Joint Return
  1. Tier 1: $32,000
  2. Tier 2: $44,000
• Single
  1. Tier 1: $25,000
  2. Tier 2: $34,000

If your client has defined benefit pension or other fixed income above Tier 2, they cannot avoid paying taxes on Social Security. If they have no non-qualified money, they usually cannot avoid paying taxes on Social Security without reducing their income. However, here is an example of a married couple who filed a joint tax return and used annuities to reduce their Social Security and ordinary income taxes (2007 tax rates):

Helping someone save over $7,000 on their taxes may look “too good to be true” but it is actually well within the ability of most annuity producers:

1. $500,000 safe assets generates $15,000 in taxable interest
   1. Use $65,000 to buy a 5-Year Single Premium Immediate Annuity to generate $14,000 income per year
   2. Put $385,000 in several deferred annuities to provide future income
   3. Leave $50,000 in a money market fund for emergencies
2. The $40,000 this couple is taking from their 401(k) is higher than the Required Minimum Distribution (RMD) — reduce it to $25,000

Smart agents will work with the client’s accountant to work the above numbers and to create the ideal product mix. The key is to get the taxable income as close to the Tier 1 income as possible. This has at least four advantages:

1. The accountant’s OK adds credibility to your sale
2. The accountant will earn extra fee income
3. If product suitability is ever an issue, you have the accountant as a friendly witness
4. The accountant has other clients that need your help — excellent referrals

In summary, this idea created a $65,000 SPIA sale, $385,000 in SPDA sales, and opened the door for an IRA rollover from the client’s 401(k).