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Financial Advisor Magazine
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November 2009 issue |
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You Make The Call |
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The decision to go Roth is anything but clear.
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By Eric L. Reiner
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Benjamin Tobias has a client whose net worth reaches into eight figures, with more than $4 million currently in a traditional individual retirement account. Should he convert it to a Roth IRA once the annoying $100,000 income limitation on conversions is lifted January 1, 2010? The client would owe ordinary income tax on the amount converted. But a Roth can provide tax-free income, and the account owner never has to take distributions.
“To me that’s a no-brainer,” says Tobias, president of Tobias Financial Advisors in Plantation, Fla. One reason he favors the move is because a chunk of the roughly $1.4 million income tax due on the conversion would be lost to estate taxes anyway. Moreover, this client intends to pass the account to heirs who can stretch withdrawals over their lives, still tax-free. “People with taxable estates who have significant money in IRAs have the greatest potential for long-term savings” with a Roth conversion, says Tobias. This client intends to convert in January, ahead of a possible rise in his investments’ value.
Meanwhile in Livingston, N.J., Michael Kay has a very similar client—taxable estate, perennially high income-tax bracket—and he thinks the right decision is a no-brainer, too. “This client is definitely not converting. I just can’t see spending all that money today to convert. We’re looking more at estate-tax solutions than income-tax solutions,” says Kay, president of Financial Focus.
What gives? Advising about Roth conversions requires exercising substantial judgment. With beaucoup projections involved, different planners may extrapolate the same facts differently. Kay acknowledges, “There are a bunch of wild cards. In situations where the decision to convert could go either way, it might come down to the client’s feelings” about the forecasts, he adds.
Still, both planners agree on this: A Roth IRA is not right for everybody, no matter how much the financial industry might want you and your clients to think otherwise. See the sidebar, “Industry Wants YOU (To Convert That IRA).”
Who Should Convert, Who Shouldn’t
The decision is incredibly client-specific. It rests on a host of individual circumstances, starting with whether the person can pay the tax to convert. “Not everybody who would like to execute a Roth conversion has excess cash outside the IRA to take advantage of it,” says Clifford L. Caplan, president of Neponset Valley Financial Partners in Norwood, Mass.
For folks who don’t have to worry about the 10% early distribution penalty, it’s perfectly acceptable to contemplate using funds in the IRA to cover the tax, according to Ben Norquist, CEO of Convergent Retirement Plan Solutions LLC, a Brainerd, Minn., company that has co-developed Roth conversion software with business partner Archimedes Systems Inc. “Retirees and near-retirees over 59-and-a-half should not by any means rule out a partial conversion simply because there aren’t assets outside the IRA available to pay the conversion tax,” Norquist says.
Assuming the client meets the liquidity prerequisite, the crux of the matter is whether it’s more advantageous to convert and pay tax now in exchange for tax-free growth going forward, or to stick with the traditional IRA and pay the tax rates in effect when the money is withdrawn in retirement, explains CPA Andy Biebl, a principal with LarsonAllen, in New Ulm, Minn. The comparison should also recognize that mandatory distributions from a traditional IRA are included in the client’s adjusted gross income (qualified charitable distributions excepted); that could limit the ability to take certain deductions during retirement or trigger more tax on Social Security benefits.
Conventional wisdom says convert if you think the future rate will be higher. “That’s a point a lot of advisors don’t understand,” says Michael Kitces, a frequent speaker and the director of financial planning at Pinnacle Advisory Group in Columbia, Md. “If you’re going to be in a higher tax bracket in the future, you’re better served by paying today’s rates and using a Roth,” Kitces says.
However, pinning down “today’s rates” isn’t so straightforward. As you probably know, 2010 conversions may be reported in full on the client’s 2010 return or spread evenly across the ’11 and ’12 returns. But as things stand now, tax rates will rise in 2011. The advisor needs to determine, on a client-by-client basis, which reporting scheme minimizes the tax bill, Kitces says.
Now comes a really wily forecast: the client’s tax bracket in retirement. Certainly it’s a function of her estimated income. “But if you’re going to talk about future tax rates, you can’t ignore the extraordinary deficits that Congress will have to deal with at some point,” Kitces says. “However, how those deficits will be ultimately manifested in tax policy is a big gray area. It doesn’t have to be higher income tax rates.”
The Future Of Tax Rates
Congress could institute new levies. Murmurs about a value-added (consumption) tax have been floating around since the Reagan years. To address Medicare’s looming shortfall, Washington could boost the Medicare payroll tax from its longtime 1.45% perch. Kitces points out that neither of these potential tax increases would affect the rate at which IRA money is taxed (or not taxed, if the client converts).
In sum, estimating the client’s future tax rate “involves a lot of personal prognosticating, economic prognosticating and political prognosticating, and none of it is very easy,” Kitces concludes.
The raging uncertainty has some clients hedging their bets, says CPA Michael J. Jones, a partner in the Monterey, Calif., accounting firm Thompson Jones LLP. “Some people are saying, ‘I’ll diversify my tax risk. I’ll do a partial conversion and leave the rest in my traditional IRA,’” Jones reports.
A Deeper Look
There’s more to Roth conversions than just a tax-bracket play, though. In building the Roth Conversion Optimizer software, Norquist’s company probed deep into the math. Beyond current-versus-future tax rates emerged two crucial variables: ability to delay or avoid taking distributions after age 70-and-a-half, and time horizon.
In cases where all these factors favor the Roth—in other words, the client anticipates a higher tax rate and can delay or avoid mandatory distributions, which lengthens the time the assets can grow—then a full or partial conversion will invariably yield projected benefits, Norquist says. Contrariwise, when all the variables line up against you, converting is unlikely to make sense.
Where things get tricky is with cases in the middle. “There’s a complex interplay between all the factors. Any one of them, in an extreme case, can trump the others,” Norquist says.
For instance, all other factors being constant, if the client’s tax rate goes up, the Roth wins. Period. “People argue, ‘You have to have a long time horizon.’ No, you don’t,” Norquist insists. To further illustrate the variables’ nonintuitive interactions, he says there are numerous scenarios in which delaying or avoiding mandatory distributions can render a partial conversion beneficial even if the client’s tax rate stays the same or drops. Bottom line, you’ll have to run the numbers for each client individually.
But finding the right software to do it could prove challenging. “A lot of software is unduly simplistic,” says LarsonAllen’s Biebl. He disdains programs that force you to assume withdrawals would occur at the same time with both types of IRAs, or that limit the analysis to an all-or-none decision. “Partial conversions are a big issue for our retired executives with million-dollar IRAs who have other resources.” They want to convert the portion of the IRA they don’t need to live on and leave it to their heirs, says Biebl, who for now is using the Roth Conversion Optimizer.
Taking Action, Or Not
With the number crunching done, the ball is in the client’s court. “There is always a resistance to paying taxes,” says Jones, the CPA down in Monterey. “Some clients will say, ‘Well, I see the analysis, but I’m not writing that check. I’ll convert half.’ After the advisor has educated the client, the client has to decide what’s best for him or her and the advisor needs to respect it,” Jones says.
The happy ending is that clients don’t have to convert on New Year’s Day and even if they do, they can change their minds as late as October 15, 2011, the deadline for recharacterizing a 2010 Roth conversion, says Kitces. “So we’re going to get a look at the direction the government is going (with tax rates) before we really have to make committed decisions. That is a little bit of a relief.” |
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CONFERENCES
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