You'd have to be nuts to recommend clients and prospects consider accelerating the payment of taxes on their retirement nest eggs, right?
Under ordinary circumstances, the correct answer is probably "Yes." But let's face it, nothing much that's happened lately falls under the category of "ordinary."
So what's the point? Very soon, over 13 million middle-income and high-income investors in the U.S. will have access to a potentially invaluable tax planning opportunity that has historically been out of their reach. What's more-and this part is pure serendipity-this newly accessible tax planning strategy is especially compelling when asset values are depressed.
So what is this counterintuitive miracle strategy that is tailor made for a depressed market, and that has previously been unavailable to so many? Three words: Roth IRA Conversion.
While the Roth IRA conversion option has been around for as long as Roth IRAs (since 1998 to be precise), the tax strategy has historically been available only to households with $100,000 or less of modified adjusted gross income (MAGI). In other words, access to Roth IRA conversions has been limited to those taxpayers who are the least likely to be in a financial position to take advantage of it.
But that's all scheduled to change. Thanks to a little-publicized provision in the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005, the income restriction on Roth IRA conversions is set to be lifted as of January 1, 2010. This opens the door to a tremendous tax planning opportunity for millions of taxpayers holding well over $1 trillion in tax-deferred IRA and defined contribution plan assets.
Before we explore the potential advantages of Roth IRA conversions, let's quickly review the basics of Roth savings. Unlike conventional tax-qualified savings alternatives, Roth IRA contributions are made with after-tax dollars (versus tax-deferred/tax-deductible contributions such as traditional 401(k) deferrals and deductible traditional IRA contributions).
While Roth IRAs do not offer the benefits of tax deductible contributions, Roth IRAs do allow taxpayers to accumulate earnings on a potentially tax-free basis. For Roth IRA earnings to qualify for tax-free "qualified distribution" at least five years must elapse from the time of the Roth IRA owner's first Roth IRA contribution, and the IRA owner must generally be at least age 59½.
Roth IRA Conversion
Now that we've reviewed the basics of Roth savings, let's look at Roth IRA conversions. The Roth IRA conversion option allows qualifying taxpayers to electively convert some or all of their traditional IRA, 401(k), 403(b), or 457(b) savings to Roth IRA savings. To do so, the taxpayer must include the taxable portion of the traditional savings in his or her taxable income in the year of conversion. That's no minor financial feat for anyone looking to convert a sizeable sum. But once the traditional assets are converted, all future growth within the Roth IRA accumulates on a tax-free basis (assuming the Roth IRA owner takes "qualified distributions").
The Roth Trifecta
Given the fact that Roth IRA conversion has historically been limited to those households with $100,000 of MAGI, it's not surprising that the strategy hasn't enjoyed widespread popularity. But with the population of potential Roth IRA conversion candidates poised to expand dramatically, forward-thinking advisors are taking a fresh new look at this often-overlooked tax planning strategy, and the key advantages afforded by it.
1) Hedge Against Future Tax Increases
With personal income tax rates at near-historic lows and the nation facing unprecedented financial challenges in the years ahead, an increasing number of financial planners are beginning to tout the tax-hedge advantages of Roth IRA savings. Given the current national debt and the looming fiscal challenges related to Medicare and Social Security, it's not difficult to envision the possibility of individuals being in a higher tax bracket during retirement, even for those clients who are currently in the upper income tax bracket (35% for 2008).
2) Tax Diversification in Retirement
Another advantage of Roth savings relates to the potential benefits of having a diversified array of both tax-deferred and tax-free sources of retirement savings from which retirement income may be generated or distributed, depending on the taxpayer's circumstances in a given year. When most or all of a client's retirement savings are held in traditional tax-deferred accounts, she does not have the flexibility to control his or her taxable income without foregoing retirement income and spending flexibility.
In other words, if a client with all of his assets in traditional tax-deferred savings wishes to keep his taxable income for the year under $X to remain qualified for certain federal or state benefits or tax deductions (or, to avoid getting bumped up into a higher tax bracket), he will generally have to curtail his distributions for the year and hence affect his standard of living. On the other hand, a client with a tax-diversified mix of traditional tax-deferred savings and Roth IRA tax-free savings would have the flexibility to control her taxable income for the year while taking additional tax-free withdrawals as needed from Roth IRA savings to maintain her desired level of income.
3) Legacy Planning
Another crucial potential advantage of Roth IRA savings that is often overlooked is the fact that, unlike with traditional tax-deferred IRA and 401(k) savings, Roth IRA savings are not subject to the required minimum distribution requirements when a client reaches age 70½. Rather, if a client wishes, she may leave Roth IRA assets untapped (and growing tax-free!) throughout her lifetime. What's more, if married, her spouse is eligible to roll the Roth IRA funds into his name following her death and further delay required distributions until following his death.
For more affluent clients who are hoping to leave a financial legacy, the Roth IRA can provide phenomenal tax-leveraged advantages when one considers that distributions are not required during the lives of the original Roth IRA owner and his or her spouse. Think about it. While a client's traditional tax-deferred savings are being forced out, annually, into that nasty taxable environment, Roth savings stay cozily tucked away in their tax-free growth environment awaiting the day when they can be turned over to the client's heirs as a tax-free financial legacy.
As we mentioned earlier, the current income restrictions on Roth IRA conversions are set to expire at the end of this year. What's more, the federal tax laws contain a special tax alternative for individuals who decide to convert in 2010. While the entire taxable amount of a conversion is typically included in taxable income in the year of conversion, taxpayers who convert assets during 2010 will have the option to forego taxes on the conversion in 2010 and, instead, include the taxable portion of the conversion in income taxes ratably on their 2011 and 2012 returns. Whether this tax-spread will be advantageous for a given taxpayer will depend on a variety of factors including the taxpayer's expectations for federal income tax rates in 2011 an 2012. Nonetheless, the forthcoming liberalization of Roth IRA conversion eligibility rules coupled with the additional conversion tax-spread options available only in 2010 both serve to ensure that the topic of Roth IRA conversion will be a time-sensitive topic throughout 2009 and 2010.
Historically speaking, Roth analysis and decision making by taxpayers has been haphazard at best. While simplistic, web-based "Roth calculators" have become the de facto standard on many financial websites, most professional planners agree that the various conventional tools and analysis fall short of meeting the requirements of the evolving and increasingly sophisticated retirement income planning field. As the Roth 2.0 landscape begins to unfold during 2009, advisors can anticipate access to an entirely new generation of educational content, analysis, decision support tools and business development strategies as an increasing number of product providers jockey for lead position in this rapidly expanding market space.
It's Not Just about Conversions
In times like these, when good news is scarce, these changes offer a great opportunity to reaffirm your value to your clients, and open doors with prospects. For business building, advisors who seize this opportunity to be "out in front" will have a very compelling message for prospects (and the press). Likewise, educating centers of influence about this change will build credibility and create opportunities for business development.
From a defensive perspective, advisors who aren't knowledgeable about Roth changes and who don't proactively educate their clients will likely get client calls also - asking "why didn't you tell me about this?" Another important reason to communicate with clients in 2009 is that among those clients for whom a full or partial conversion is appropriate, many will need planning time to be able to pay the conversion taxes.
Properly conducted, a thorough Roth IRA conversion analysis will set the stage for a comprehensive retirement income planning discussion - and, ultimately, open the door for a much broader relationship with both new and existing clients.
Ben Norquist is president of Convergent Retirement Plan Solutions and Michael Slemmer, CFA, is a prinicipal with AdvisorsTrustedAdvisor.com. Advisors Trusted Advisors and Convergent Retirement Plan Solutions helps advisors and retirement plan providers understand the technical aspects of and act on the unique marketing opportunity offered by Roth in 2010. The firms are hosting a workshop called The Roth Factor: A Conversion Opportunity on February 5 in Boston to help wealth management professionals become well-equipped to do just that.