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Urgent Alert: The IRS Shuts down
Roth IRA Conversion Scheme Using Annuities

Tim Berry, JD of the Tax Academy (educational board member to the WPI) forwarded me a lawsuit the IRS just filed against a marketer of a Roth conversion plan that has forced me to issue this urgent Alert.

The IRS vs. Edwin Lichtig III

Here’s the headline of this lawsuit: Walnut Creek , Calif. , Firm Allegedly Helped Customers Avoid Tax on More Than $25 Million Through Insurance and IRA Scheme

On November 24, 2008, the IRS filed a lawsuit to essentially shut down what they call a scheme involving Roth IRA conversions using high surrender charge annuities.

To read the actual court document filed regarding the IRS shutting down
Roth IRA conversion scheme using annuities follow this link.

The scheme goes by the name of the Financed Roth Conversion Strategy (FROCO).

As we all know, clients in any tax bracket will be able to convert all of the money in their traditional IRA to a Roth IRA in 2010 (currently the limit is a $100,000 conversion for those who earn less than $110,000 a year or $160,000 a year if married filing jointly).

Why would someone want to convert a traditional IRA?

Roth IRAs allow money to grow tax free and come out tax free in retirement (after 59.5).   With Traditional IRAs, clients have to pay income taxes on all the money as it is removed. So the theory is that it is better to “convert” a traditional IRA to a Roth IRA (which requires you to pay income taxes NOW on the converted funds) so that the money, for years to come, can grow tax-free and be removed tax-free in retirement.

To date, I’ve not opined much on Roth conversions because I’m not so sure the law will remain as it is today with an unlimited ability to convert in 2010.  As we creep closer to the end of 2009 and if the laws have not changed, I’ll then break down the numbers to tell you the ages that a Roth conversion makes financial sense for.

How does the Roth conversion scheme work?

It’s really quite simple and makes some sense when you think about it.

As stated, when you convert a traditional IRA to a Roth, you have to pay income taxes on all the money at the time you make the conversion.  The hope is that the money, once in a Roth, will work out better in the long run because the money then grows tax-free and can be removed tax-free in retirement.

How can you help mitigate the income taxes due upon conversion?  The simple answer is that you need to depress the value of the assets before conversion.

What’s a good way to do that?  How about buying an annuity with a huge surrender charge?  Sure, that would do it.  And, the bigger the surrender charge the larger the commission. What a bonus for the agent selling this concept.

Let’s look at an example of how the FROCO plan would work to help clients avoid income taxes upon converting an IRA to a Roth IRA.

Assume you had $100,000 in an IRA and wanted to convert it to a Roth IRA.   Further assume that you are in the 20% tax bracket.  Further assume that prior to conversion you purchased an annuity with a 20% surrender charge in year one.

With the FROCO plan, the client would buy the annuity and then convert the IRA to a Roth IRA and would base the taxes due not on the $100,000 account balance, but instead on the $80,000 cash surrender value of the annuity purchased inside the IRA.

What was the tax savings?

$20,000 x 20% = $4,000

It’s not a huge amount of money, but apparently this plan as well as another I’ll discuss in a separate upcoming newsletter were mass marketed in some insurance circles and the IRS estimates that 25 million dollars in income taxes have been illegally avoided.

When I first thought about the plan and how it worked, it logically made some sense to me.  I have not done research to determine the legality of it, but apparently the IRS has and thinks the plan is illegal. What’s worse is that the plan is so simple that clients will understand it and therefore, it will be very easy to sell the concept to the masses.

Mass marketing

If you read the court document, you’ll notice that the IRS was really displeased with the way the plan was marketed. The marketing material basically flaunted the plan as a tax avoidance plan.  Doing so is never a good idea.  What is more prudent with all tax-favorable planning is to tout the other real and tangible benefits (and any decent tax plan has a primary benefit to the client besides reducing taxes) and simply to state the tax benefits not flaunt them.

What can we learn from this tax avoidance plan?

Selfishly, what you can learn is that it’s important to work with firms like the Wealth Preservation Institute who try to get out to advisors the best and most timely information in the industry so you can provide the most compliant advice to your clients.

At this point it’s a little too early to draw any conclusions as to the merits of the FROCO plan.  What I know is that the IRS is not very happy with the plan and filed a lawsuit to stop it from being marketed.

We can learn that when marketing tax favorable plans to clients, we should always be touting the real benefits of the plan(s) first and then discuss the tax benefits.  If a plan does not have other real benefits besides tax savings, it’s a plan you should stay away from due to the fact that the IRS will eventually hunt it down and kill it (and take marketers of the plan with it).

If you have friends or colleagues in the insurance field, I would suggest you forward this to them to make sure they are aware of this tax scheme so they will know to avoid it.

I’ll follow this case with the help of Tim Berry and we’ll get you updates as they become available.  For now, I’d stay away from Roth conversion plans using annuities as a reason to dump the value of the assets in the IRA prior to conversion.

Roccy DeFrancesco, J.D., CWPP™, CAPP™, or CMP™
Founder, The Wealth Preservation Institute
Co-Founder, The Asset Protection Society