Plan for Cutting Tax Bite in Roth IRA Conversion Could Cost Retirees
A Walnut Creek, Calif., insurance agency is pitching an investment product with the promise that it could provide big tax savings for senior citizens. But if they bite, consumers might lose significantly more than they save.
In regular conference calls, GSL Advisory Services urges financial planners to sell their clients a complex retirement product. It is advertised as a way for retirees older than 59 to convert a traditional IRA into a Roth IRA with “no upfront tax cost.”
The claim is an exaggeration--tax is still due on part of the converted amount, though GSL would lend clients money to pay it.
And though the company does have a plan to reduce the income-tax cost on conversions, here’s the trouble: GSL’s plan could cause the participant to either lose significant money on the transaction or risk being accused of tax fraud for misstating the IRA’s value to the Internal Revenue Service, tax and financial planning experts say.
For the planner or broker who sells it, however, it’s highly lucrative. Selling a client on this plan would generate $17,000 in commissions for each $100,000 in IRA assets pulled into the program, said Edwin Lichtig, the GSL principal promoting the program on a recent conference call.
Option of Transferring Assets Into Roth IRA
The GSL program appears to be an effort to capitalize on the huge potential market for IRA conversions.
Nearly $2.5 trillion is now invested in individual retirement accounts, according to the Employee Benefit Research Institute in Washington. Most of that money is in traditional IRAs, which provide upfront tax deductions but are subject to income tax when the money is withdrawn in retirement.
A new type of IRA, the Roth, was introduced in 1997. Roth IRAs don’t provide upfront tax deductions, but they allow tax-free growth within the account. Also, gains accumulated in a Roth are exempt from tax when withdrawn in retirement.
Many Americans have the option of transferring assets in their traditional IRA into a Roth, which in addition to the tax benefits also provides some estate planning benefits. However, those who do such IRA “conversions” must pay tax on the previously untaxed value in the traditional IRA.
The tax bill--which often amounts to 30% to 50% of the account value--is so hefty that few of the estimated 33 million owners of traditional IRAs have converted to Roth accounts.
GSL maintains that it can cut the tax cost by arranging for investors to buy an annuity contract with their IRA assets before the account is converted.
An annuity is an insurance contract that provides either fixed or variable payments to the buyer in the future, usually in retirement.
The particular annuity GSL is touting charges owners a huge fee if they cash out of the account during the first several years. As a result, the early-cash-out value--called the “surrender value”--is 25% less than what the IRA account holder pays for the annuity.
GSL promises that its IRA custodian--a bank that will handle account paperwork--will report the surrender value as the taxable value when the policy is converted to a Roth IRA. That way, GSL says, the IRA holder saves income tax on the difference between the actual purchase price and the surrender value.
Conversions Reported at Fair Market Value
But there’s a big catch: The IRS maintains that the only way this works for tax purposes is if the consumer truly loses money.
IRA conversions must be reported at their fair market value. If the reported surrender value is artificially low, it’s tax fraud, said Don Roberts, an IRS spokesman in Washington. If the IRS discovers that a custodian has been misreporting the value of customer accounts, it can audit that company’s clients, assessing back taxes and penalties years after the transaction is complete, he added.
“The IRS can always look at an overall transaction and say that regardless of the form, the substance is tax abuse,” said Preston Caves, a Manhattan Beach-based financial planner. “I don’t know if it makes economic sense for a person to buy a product with that type of surrender charge, and if it is out of the scope of what a reasonable person would do, it begins to [look like] a tax dodge.”
GSL’s Lichtig refused to answer follow-up questions from a Times reporter about how the program could benefit investors without potentially running afoul of the IRS.
He maintains that The Times reporter improperly listened in on what he said was a call intended for “agents only.” Although he e-mailed this columnist invitations to the call--and advertises the sessions on the Internet--he said he didn’t understand that the reporter would be “acting as a journalist” while listening in.
During his conference call, Lichtig said he could guarantee the tax savings because GSL had secured the services of a “friendly custodian,” which had agreed to report the surrender value as the fair market value for tax purposes.
Lichtig contended that the surrender value is proper fair market value, even though it isn’t the value most IRA custodians would report.
“Most custodians are going to report the account value,” he said in his marketing pitch. “We have lined up a custodian who reports the surrender value.”
When asked by another listener whether the IRS would agree with this assessment of the fair market value, Lichtig said it was unlikely that the IRS would ever find out.
“We have an unauditable trail,” he said on the conference call. “The only thing that shows up on the guy’s tax return is the 1099R, which is issued by our custodian bank.” A 1099R is a tax form filed at the time of an IRA conversion, noting the taxable income received by the taxpayer.
If an investor using the GSL product chooses to cash out of the annuity early, the surrender value of the contract would become the real value, potentially avoiding IRS concerns. But then the investor faces the penalty of the surrender charges--$25,000 on a $100,000 IRA conversion.
“The key point is the fair market value of the annuity,” said the IRS’ Roberts. “It is possible that the fair market value is less than the amount you put into it, but that raises the question to the taxpayer: Is the tax savings worth the loss?”
Someone in the 30% federal tax bracket who converts a $100,000 taxable IRA under the GSL plan would save $7,500 in taxes, but if the investor then chooses to cash out of the contract early, the bottom line is that he or she would lose $25,000 to save $7,500 in taxes--a net loss of $17,500.
Even if an investor holds on to the annuity contract and avoids problems with the IRS for reporting the surrender value as the true value of the conversion, there’s another high cost in the long run: the fees charged by the program.
The particular annuity that GSL uses in this plan pays a 17% commission to the planner or broker who sells it. For its part, GSL gets a portion of the commission from any planner using its program.
The commission isn’t paid directly by the consumer. Rather, the insurance company offering the annuity pays the broker at the time of the sale.
However, consumers ultimately pay the commission through fees assessed on their accounts over time.
With annuities, the commission costs are reflected in reduced investment returns over the life of the contract.
“The big commission upfront is amortized over the surrender period,” said Jack Marrion, founder of the Advantage Group, a St. Louis-based insurance research and consulting firm. “Higher costs mean lower returns.”
But for some financial planners, the risk of running afoul of the IRS is reason enough to be wary of the GSL plan.
“Anything where it’s clear that the underlying purpose is to avoid tax comes under IRS suspicion,” said Laura Tarbox, a Newport Beach-based financial planner.
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Kathy M. Kristof can be reached at kathy.kristof@latimes.com
