MailBag: Roth IRA Conversions With Higher Tax Rates And Hybrid Life/LTC Insurance Policies

Posted by Michael Kitces on Thursday, November 29th, 12:03 pm, 2012 in MailBag

Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I will occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis!) and my response, in the hopes that the discussion may be useful food for thought.
In this week's mailbag, we look at two recent inquiries: 1) whether or not it's a good plan to do a significant Roth IRA conversion if your client has a high conviction that tax rates are going up in the future (and/or what the downside risks of the strategy are); and 2) what is and isn't guaranteed if you purchase one of the new hybrid life/LTC insurance policies, and the potential risks of owning such policies.



Question/Comment: Well-off 57-year old MD with plenty of cash and a conviction that tax rates are going much higher is inclined to convert his IRAs to Roths. Has cash to pay taxes.  Any major reasons he shouldn’t (other than the possibility of a VAT in our future)?

This seems fairly reasonable given the client's tax outlook, as current versus future tax rates are a primary driver of the Roth versus traditional IRA decision. However, there are a few ‘risks’ or downside issues to be cognizant of...

First of all, if he’s not already in the top tax bracket, bear in mind that a large conversion driving up his current tax rate does most of the damage now that higher future tax rates would have done anyway. In other words, if a huge conversion is going to take him from 28% to 35% brackets today, it would have been better to “just” go from 28% to 31% next year when rates rose as scheduled. The higher his current tax bracket is, the less of a concern this is.

Second, there’s a difference between a higher tax BURDEN in the future, and higher marginal tax RATES in the future. As I've written in the past, we could end out with a higher tax burden but in the form of equal or less INCOME tax and more VAT tax, which means the total taxes paid may be higher but Roth will actually be an unfavorable action (because the future rates on IRA distributions may not be higher). Alternatively, if we do a Simpson-Bowles kind of tax reform, we can have a higher tax burden because there are fewer deductions, but lower marginal tax rates; in that scenario, it would have been better paying 20-something-percent tax rates after the tax reform than converting now at current rates.

The final caveat to the strategy is simply that, the more you convert, the less pre-tax money you have to be taxed in the future, and the lower your future tax rates are (and lower future tax rates make Roth conversions bad). As a result, it's rarely ever a good to deal to convert ALL of someone’s IRA funds. At the extreme, just convert “most” of it. For example, if I have a $3M IRA, I’ve got a lot of looming future taxes. But if I’ve converted $2.5M of it, “just” a $500k IRA with "just" $20,000 of RMDs at age 70 1/2 is easy to manage to stay in the lower tax brackets (especially if you can supplement retirement spending with a $2.5M Roth!). Thus, the more the client converts, the less incentive there is to convert the rest. So even when doing a “really big” Roth conversion, where all the preceding factors discussed above are navigable, I'd still only ever recommend converting “most” of the IRA, and not “all” of it.


Question/Comment: A great client is considering one of the hybrid life/LTC policies, where you pay like $100,000 in a lump sum, and have the coverage for life with a death benefit. Question---if a client purchases one of these type policies, can the insurance company down the road change the benefits promised in any way?

With hybrid life/LTC policies, the following things are typically guaranteed at issue:

  • Cash value guaranteed not to decline below original principal, and remain fully liquid (no surrender charges)
  • Specific long-term care insurance charges that will be deducted from the policy (no more, no less)
  • Maximum life insurance death benefit charges that will be deducted from the policy (may start out more favorable than maximum)
  • Minimum interest rate for growth on the cash value (in today’s environment, many policies start out at this minimum guarantee)
  • Formula to determine the amount of long-term care insurance benefits (provides a guaranteed minimum amount, but typically may rise if/when/as cash value grows)
  • Formula to determine amount of death benefit (although the death benefit is guaranteed not to be lower than what is specified in the contract, some hybrid life/LTC policies are designed up front to have a declining death benefit in later years, so “guaranteed” doesn’t necessarily mean “level”)

As a result of these guarantees, policyowners generally have certainty about:

  • Cash value remaining liquid and never falling below the original contribution amount
  • Minimum amount of long-term care insurance benefits that may rise over time (or remain level in some cases)
  • Some death benefit, which may be level or may change in later years (but policy illustrations at the time of purchase should show these guaranteed changes)

The one very important thing that is NOT guaranteed in a hybrid life/LTC policy, though, is what the interest crediting rate for the cash value will be if/when interest rates rise (which ostensibly they will at SOME point, sooner or later). As a result, there is a very real “risk” that when rates ultimately go up, the interest rate on the hybrid policy may lag, and the policyowner could end up with cash value stuck at a below-market rate of interest. 

In point of fact, this is partially WHY insurance companies are willing to guarantee the long-term care insurance costs – since they have the cash value, they don’t have to raise LTC premium costs to make more money, when they can simply under-credit on the growth rate. And unfortunately, policyowners would have little alternative – the cash value may be liquid, but taking the money out to reinvest it at higher rates would surrender some or all of the insurance benefits. If the policyowner wants to keep the insurance benefits, he/she must accept whatever interest rate the insurance company is giving. The good news is that, again, original contributions remain guaranteed, so this won’t result in an outright loss, per se; however, the reduction in wealth due to foregone growth over the span of years or decades could potentially be very large.

On the plus side, there’s limited risk of this dynamic right now, because rates are so low that most policies already ARE crediting the guaranteed minimum rate, and can’t go any lower. But if the policy is going to be held for the long run, it’s important to remember that the policy is at risk to lag to the upside, potentially quite materially. 

The alternative, of course, is for the client to simply invest the $100,000 and use the interest/yield/dividends/growth to pay premiums for traditional long-term care insurance… which guarantees the principal, provides the coverage, and leaves all the return upside with higher yields in the control of the client. There is some risk that the LTC premiums may increase, as they aren’t guaranteed, but that’s the tradeoff for investment flexibility. On the other hand, it’s important to note that the risk of LTC premium increases is probably LOWER now than it’s ever been in the history of LTC insurance!


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