Roth conversions are nothing new; the ability to convert to a Roth has existed since 1998, the year that Roth IRAs came into being. The conversion rules were liberalized somewhat in 2005; however, the opportunity to initiate a Roth conversion has proved elusive to most clients. That's because current rules prohibit households with more than $100,000 in modified adjusted gross income (MAGI) from converting a traditional IRA to a Roth IRA. Come January 1, 2010, however, the rules will change. The income cap will be lifted. As a result, an estimated $3 trillion sitting in traditional IRA accounts will become eligible for conversion.
Clearly, the lifting of the income cap will create an opportunity for many clients and prospects. It will also create an outstanding business opportunity for financial advisors. That's because decisions such as whether to convert, how much to convert, when to convert and the timing of tax payments are more complex than they first appear. Furthermore, the popular press is already alerting the public to the Roth conversion opportunity, so the demand for advice will be strong. Financial firms both large and small will fuel demand even more with their marketing.
As is often the case with complex financial decisions, there are some general rules of thumb that will be put out as guidance for those thinking about conversion, but in reality, each client's situation is unique. The only way to arrive at a satisfactory decision is to run the numbers. Unfortunately, this is not going to be as easy as it sounds. Many do-it-yourself investors will get incomplete answers because they turn to free online calculators. Some advisors may fall into a similar trap if they fail to perform their due diligence before selecting a software application to aid them in their Roth conversion analysis.
Before we discuss any specific firms or products, it may be useful to discuss a framework that readers can apply when choosing their conversion software. The discussion must begin with three key factors (just as it did with Monte Carlo software last month): the quality of the model, the quality of the inputs and the quality of the explanation. Let's look at each in turn.
An evaluation of the quality of the model involves a great many things. Clearly, a program should get the rules right. It should also let you opt to pay the tax in 2010, or you should be allowed to pay the tax over two years-half in 2011 and half in 2012.
Any decent tool should also give advisors the option of paying the taxes for the conversion out of the traditional IRA or from another source. Ideally, you want the option to model the growth of the funds used to pay for the conversion; that is, you present what would happen if the conversion did not occur and you instead took the funds earmarked to pay the income tax for the conversion and put them in a taxable investment account. Most comprehensive financial planning software will do this, but many stand-alone programs will not.
Inputs are also important. Good default options can speed data entry, lowering your costs of producing a report. If you do not like the program's defaults, you should be allowed to alter them, but some programs require you to override the defaults each time you run a plan, if they allow it at all. We indicated earlier that you have the option in 2010 of delaying payment of taxes till 2011 and 2012. If you want to model this scenario, look at how your software handles this task. Can you simply check a box to choose this method, or are additional steps required?
If you choose to postpone the taxes until 2011 and 2012, it is possible that you will pay higher taxes on the conversion, since many provisions of the Bush tax cuts are set to expire. The software should illustrate this; it should also allow you to take into account what would happen if the sunset is postponed for some, or all, tax brackets.
If you want to illustrate a scenario where you keep the money in a traditional IRA and invest the funds that would have been used to pay the conversion taxes, the assumptions you make regarding those investments will impact your findings. For example, if you assume that the money will be invested in an asset that is taxed at the client's marginal rate, and if you assume the money will be spent beginning at age 65 or 70, the results will be different than if you assume the funds are invested in a broad market ETF or Berkshire Hathaway stock that is highly unlikely to generate any tax until sold. Furthermore, if the intent is to pass the asset to the next generation, the (hopefully) appreciated asset will get a step-up in basis, reducing or eliminating the income tax impact on the heirs. Some programs allow you to easily alter scenarios for these funds; others do not.
No matter how good the software is, the insights provided by the advisor are crucial. For example, if your client is in a top marginal tax bracket, and if you believe that marginal rates will be higher in the future, you should certainly illustrate what a Roth conversion would look like under that scenario, but it is imperative to inform the client that other outcomes are possible.
If you know that your clients nearing retirement are likely to be in a high marginal rate after retirement, and if you know that the money they are thinking about contributing to a Roth will likely be needed for living expenses sooner rather than later, it probably does not make sense to recommend a conversion. If you do, you had better be sure to advise the clients, in writing, that your recommendations are based on the premise that the money will not be spent anytime soon. The conversion becomes more attractive when the money is not needed and if the client is likely to stick to the plan when converting but unlikely to save the additional funds that would be spent on the conversion taxes.
There are estate tax issues that are beyond the scope of this article, but, generally speaking, comprehensive programs that integrate a Roth conversion into a plan will illustrate the estate tax impact. Many stand-alone calculators do not (with the exception of Brentmark's Retirement Plan Analyzer).
Please bear in mind that good calculations are not enough. All software forces us to make assumptions about future tax rates, the future spending habits of our clients and many more unknowns. If we discover that our assumptions are faulty shortly after the conversion, we have some time to undo the conversion through a recharacterization and start over again (at least until October 15 of the tax year following the conversion if an extension is filed). But once the recharacterization deadline has passed, we are locked into the conversion.
Since there are many factors to consider before doing a Roth conversion, and since some of these are behavioral (the plan is useless if the client does not follow it) the best we can hope for with conversion software is that it allows us the freedom to illustrate the scenarios we want to illustrate.
With those thoughts in mind, let's look at some comprehensive financial planning programs that are currently being updated to allow for Roth conversion planning and two applications that specialize in the analysis of Roth conversions.
In November 2009, EISI (www.eisi.com) will be releasing an incremental upgrade to NaviPlan's "Standard" and "Extended" versions. The scenario manager in NaviPlan Standard will allow you to choose the two-year tax payment option in 2010, and it will allow you to designate which assets are to be converted. The reports will even highlight the value of the applicable IRD assets. A company spokesperson indicated that the scenario manager in Standard will allow advisors to change most assumptions, with the exception of tax rates (though this may come in the next release, scheduled for the first quarter of 2010). As for the sunset provisions, you can only currently change them at the plan level, so if you want to change assumptions about tax rates or sunset provisions, you would have to run separate plans.
MoneyGuidePro (www.moneyguidepro.com) is currently being upgraded to enhance its Roth conversion capabilities. A new goal strategy called Roth Conversion is being added. The result of any Roth conversion strategy will be displayed using both a straight-line analysis and a probability analysis. Using the "what-if" portion of the program, the advisor will be able to look at multiple scenarios side by side. For example, you can look at scenarios that take into account different income tax rates in the future. The program's default assumption is that Roth assets will be spent last, but advisors will be able to manually alter the spending order. The software plans to offer check boxes for the 2011/2012 tax election in 2010, and it gives users full control over projected returns and tax rates.
MoneyTree (www.moneytree.com) packs a lot of useful tools into its new release of Distribution Solutions. It analyzes lump-sum distributions. It compares taking lump sums against taking out a monthly pension. It analyzes early withdrawals allowed under IRS Rule 72(t). And it analyzes various pension annuity options, including the option of taking a single life annuity and purchasing life insurance to provide a survivor benefit. In addition to those things, it also offers an IRA-to-Roth conversion tool.
The MoneyTree conversion tool offers good flexibility. It allows the advisor to set a return rate for the current IRA account, and if desired, a different rate for the Roth. It allows for a current income tax rate, which can be changed once in the future at a time designated by the advisor. Conversions can take place at any time, and multiple conversions over time are accommodated. For 2010 conversions, you can choose to pay the tax in 2011 and 2012. The conversion tool attempts to account for the outside money spent on the conversion by adding it into the present and future value of the Roth account, but this treatment is awkward. It would be better if the software included the tax dollars along with the traditional IRA and projected out the value of the sum of the two.
Like MoneyTree's solution, Brentmark's Retirement Plan Analyzer includes a number of specialized planning tools. Brentmark is busy at work updating the Retirement Plan Analyzer, but I reviewed the previous version's handling of Roth conversions, and it looked good. It can illustrate the growth of the funds that would have been used to pay the conversion tax. A new version is due for release shortly.
The new 2009 version will include a Roth-conversion-plus-Social Security calculator. No information about this tool was available at press time, but it will presumably help analyze and optimize the timing of Roth conversions to minimize their impact on Social Security benefits.
Each advisor will have to do a little legwork to determine which Roth tool is best for them. The time to do that research is now, so you can be ready to service existing clients when year-end meetings roll around, and so you can market your services to new prospects soon.
The lifting of the income limits on Roth conversions and the special tax deferral available in 2010 offer a chance to serve existing clients and attract new ones, but good software will be essential if you are to succeed. Evaluate your options now so you can take full advantage of this opportunity.