The Hidden Costs of Roth Conversions: Is There a Better Way?

Not paying high taxes in retirement is just more fun.

A recent Wall Street Journal article highlighted the growing trend of retirees opting for Roth conversions, citing the current favorable tax environment and the potential for tax-free income in retirement. While this strategy might seem appealing at first glance, there are critical pitfalls—especially when funding the conversion by liquidating brokerage accounts. Let's break it down and explore a smarter, more efficient alternative.

The Double-Tax Trap

When retirees liquidate their brokerage accounts to pay the taxes on a 401(k) distribution, they often overlook the capital gains tax that will be triggered on the sale of appreciated assets. This creates a double-tax situation:

1. Capital Gains Tax: On the liquidation of investments.

2. Income Tax: On the 401(k) distribution.

For example, imagine a retiree sells $50,000 worth of brokerage assets to cover taxes. If those assets have appreciated by 30%, they will owe capital gains tax on $15,000 (the gain). Assuming a 15% capital gains tax rate, that’s an additional $2,250 in taxes, reducing the overall efficiency of the Roth conversion.

A Better Way to Execute a Roth Conversion: Index Universal Life (IUL) Policies

I propose that a better way to do a Roth conversion might involve using a well-funded Index Universal Life (IUL) policy to pay the taxes on the 401(k) distribution. Here’s why:

• Tax-Advantaged Growth: Cash value in an IUL grows tax-deferred, often tracking market indices for upside potential while protecting against losses.

• Access to Funds via Non-Direct Recognition Loans: This feature allows policyholders to borrow against their cash value without interrupting the growth of the underlying funds.

  
  

What Is a Non-Direct Recognition Loan?

In simplest terms, a non-direct recognition loan is a mechanism that lets you borrow from your IUL policy while the funds you borrowed against continue to earn interest or returns as if they were never touched.

Here’s how it works:

1. The IUL provider gives you a loan using your cash value as collateral.

2. The loan does not affect the growth of your policy.

3. You repay the loan (or not.... see next point) on flexible terms, often with low-interest rates.

This is a stark contrast to liquidating brokerage assets, which not only stops their growth but also creates an immediate tax liability.

4. You actually may not have to repay loans from the policy directly while you're living , and you can allow the death benefit on the policy to cover any outstanding loans and the remaining death benefit (after loans are taken care of) will go to your beneficiaries.

Why This Matters

By leveraging an IUL policy:

• You avoid triggering capital gains taxes.

• Your investments remain intact and continue to grow.

• You have a predictable and flexible method to pay the taxes on your 401(k) distribution.

The Big Picture

While Roth conversions can be a valuable retirement strategy, the method used to fund the conversion is just as important as the decision to convert. Liquidating brokerage accounts to cover taxes often results in unnecessary tax burdens and diminished overall wealth. Instead, establishing a well-funded IUL policy not only helps you execute a tax-efficient Roth conversion but also enhances your overall financial strategy with additional benefits, such as death benefits and long-term growth potential.

Take the Next Step

If you’re considering a Roth conversion or looking for ways to optimize your retirement strategy, I can help. Let’s work together to build a tailored plan that minimizes taxes and maximizes your wealth potential. Contact me today to explore how an IUL policy or other strategies might fit into your retirement goals.