(Dow Jones) Financial advisors should beware of a looming hangover from last year's boom in Roth IRA conversions.
In 2010, while facing an unclear future over tax rates, hundreds of thousands of people converted tax-deferred retirement account holdings into Roth IRA accounts. The bull rush included a mini-stampede in December as thousands of converters rushed to file their paperwork before New Year's Day, eager to pay up-front tax bills at current rates in exchange for tax-free account withdrawals in retirement.
Now, in the wake of Congress's late-hour decision to extend the controversial Bush-era tax rates, financial advisors and taxpayers have a nearly two-year window to reexamine those conversions. Individuals who filed hastily can revisit their decisions under calmer circumstances. Financial advisors, for their part, should keep an eye on converted accounts, since subsequent investment losses or other changes in a client's life could mean an "undo" makes the most sense.
"We've got a couple of accounts we're going to recharacterize," or undo, after converting them last year, said Lisa Kirchenbauer, president of Omega Wealth Management in Arlington, Va. She said one client, for example, will be in a lower tax bracket than expected in 2011, which means the client can pay fewer taxes by redoing the conversion this year instead.
People who rushed to convert their accounts "now have two more years to kind of back out of it," said Robert Seigmann, a financial planner in Cincinnati.
Taxpayers have until mid-October of the following year, or the deadline to amend tax returns, to undo a Roth IRA conversion. Holders who converted accounts in 2010 were allowed to spread the tax liability across two years--a rule since expired.
Seigmann just took on some clients who decided last year, before hiring Seigmann, to convert $800,000 tax-deferred retirement savings into a Roth IRA account. After doing their own research, they "thought that 2010 was the only year they could convert the account," said Seigmann, who is chief operating officer at Financial Management Group Inc. He said he plans to help the client reverse about half of that conversion as part of a broader strategy to keep subsequent investment gains intact, since the account is now worth $915,000.
Thousands of clients will require similar analysis. The brokerage Merrill Lynch, for example, which is a unit of Bank of America Corp. (BAC), undertook more than 56,000 Roth IRA conversions in 2010--nearly five times the 12,000 it executed in 2009. The company's data also illustrate the end-of-year rush: Its advisors executed more than 11,000 conversions between Dec. 17 and New Years Eve.
Although financial markets have mostly risen since January, the most obvious candidates for reversals are any accounts that have fallen in value since conversion, said Mitch Drossman, national director of wealth planning strategies for U.S. Trust, also a division of Bank of America. "Undoing [conversions] is a defensive strategy, so we hope our clients never have to take advantage of it," Drossman said.
Reshuffling retirement accounts, of course, remains a complicated and time-consuming task--and prone to philosophical debates about the merits of delaying tax bills and where federal tax rates will sit decades into the future.
But advisors can avoid the worst pitfalls by working hand-in-hand with knowledgeable accountants or tax preparers. One key reason: Undoing some conversions can nullify deductions and trigger other unintended tax consequences. And since no two clients are alike, the decision of whether to convert an account may hang on a variety of crucial details.
For each conversion or undo, "we work the numbers and look at the client's specific situation," said Kirchenbauer. "But we always run it by [the client's] tax advisor, just in case we're missing something."
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