Will an Annuity Bonus pay for a Roth Conversion?
Roth conversions have been a hot topic in the past few years. I’d rather call them panic conversions because everyone has been worried about the Trump tax cuts set to expire in 2025. Candidates on both sides had promised to extend parts of it no matter what, so my expectation was that paying large amounts of taxes just to convert assets to tax-free would mostly be a waste of money. It was good business for other advisors who specialize in fear-based selling but we use logic and reason here that lead us to thoughtful decisions. And Trump was reelected so I’ve been partially correct so far.
This June, I released the podcast “Financial Conspiracy Theories” that brought to light several cases of broken Federal promises, which leads into question whether Roth IRAs will always be tax-free. The tax code states only that distributions shall not be includible in gross income, which is exactly how social security started. Now if you make too much money then social security is taxable to some extent. Just like Medicare parts B and D, there’s a means test and you can’t convince me that Roth IRAs won’t be on the chopping block one day.
Every two years I have to complete 24 hours of continuing education in order to keep my license. That came this year and I just finished my coursework and tests. One course was specifically about IRAs of all types and during the reading section something caught my eye. When it came as a question on the test my suspicions were strengthened. I took a screenshot of the multiple choice question and posted it below. You can draw your own conclusions…
Take my word for it. I got this question correct and you should too. We all know that deductibility of contributions is not characteristic of a Roth IRA. Do I need to point out that “possible tax-free distributions after age 59 ½” is a characteristic?, emphasis on the word POSSIBLE! These tests are very literal and this is what the regulatory agencies want to train us professionals to say. There’s no more obvious way to point out that the door is open and my contention is that someday a means test is very likely. Don’t sell out to complete Roth conversions because it’s just as risky as many other strategies that have no guaranteed outcome.
This brings me to my next case of predatory sales tactics that directly hits the title of this newsletter. Dozens of people have asked this question because there are guys out there claiming that a large annuity bonus can pay for a Roth conversion. I’ll admit that a bonus can help to some extent but it’s misleading because you still have to pay the taxes out of pocket to get it done. There are several reasons why I think this is a poor idea but if you consider these things and still want to do it then by all means go ahead.
The best pure bonus from a reputable company is 13% and it has to be a fixed indexed annuity because those are the only contracts that currently allow for partial Roth conversions in the contract. You can go as high as a 20% bonus if you are willing to pay a fee but the ongoing reduction of cash value with a fee negates the benefit of the bonus. Other benefits come with the fee so choosing the larger bonus needs to be done with an additional purpose besides just the extra money. Sticking with the no-fee bonus, your tax rate on the conversion needs to be less than that amount or it obviously does not make sense. A 22% tax bracket with a 13% bonus directly contradicts that claim that the bonus pays for the conversion.
The overall premise is that you are getting free money that recoups the out of pocket taxes paid. But the kicker is that any cost recovered is in the annuity. Making conversions to Roth and taking withdrawals to pay for it create quite a mess, although it can be managed. The lesson here is that you need other reasons to own the annuity in the first place. If you successfully convert all of the funds, the end result is that you have a big Roth IRA annuity. That has to be what you want because the tax savings are questionable at best. If you have to want the annuity for other reasons, then go ahead and play with conversions all you like.
Conversions are best done with after tax money to keep it clean. If you don’t have enough cash on the side to pay the taxes then you are most likely not in danger of being forced into an unwanted tax bracket. For most people who don’t need funds from a Traditional IRA, it’s far more tax effective to take systematic distributions and invest the proceeds net of taxes. Then transfer to RMDs when it’s time. Most are likely to pay the least amount of taxes over time doing it this way.
Let’s look at a best case scenario for this strategy. In that case, taxes would be completely offset by the bonus and you are light the cash somewhere else. It amounts to a larger investment in the annuity because it cost you all of your IRA and some additional money on the side. And we all know that bonus annuities come with lower growth potential so that’s what you get out of the deal. By all means use the bonus to boost the cash value of the contract but it will never pay for a Roth conversion and the result is lower growth over time.
I will never say that Roth conversions are always bad and bonus annuities should never be used, but the two together are nothing but a questionable sales pitch. No doubt thousands of people were convinced otherwise and I’ll stand by that because my experience in online advertising has revealed several other questionable trends. Again, you must have other reasons for wanting the annuity and if the Roth conversion is that important then do that too. I won’t sit here and pretend that you’re outsmarting the system by doing it that way and I know the Feds want their money upfront. Be careful, however, because they might want more at the end. It won’t be the first time it’s happened.
Have a great weekend!
Bryan
Watch Episode 162: Will an Annuity Bonus pay for a Roth Conversion?
Last Updated on December 6, 2024 by Bryan Anderson
