The interplay of the key variables becomes far more important when you are advising high-net-worth families that won't need the income from their Roth IRA to live on. For instance, if in addition to the $700,000 in IRAs, this same couple also has a pension plan and other investments, they may decide that they do not need to make any monthly withdrawals from their Roth IRA account.
In Figure 4, you see how taking no monthly withdrawals catapults the net benefit of converting to the Roth from $49,000 to $1.17 million, almost all of which goes to the couple's beneficiaries. A residual amount goes to the offspring of the couple's beneficiaries (Figure 5).
Being able to isolate each of the key variables is where a tool like this one comes in handy. The dynamic interplay of factors in the conversion decision creates too many moving parts for a simple tool.
Some advisors will likely object to this new breed of Roth IRA tools as "black boxes." To allay those fears, Norquist has published a four-page list of assumptions that are made in the optimizer, explaining how outside assets and distributions are treated. State and local income taxes are not factored into the equation, and no inflation rate is applied to monthly withdrawals taken by retirees for income. While some advisors may not like all of the assumptions, it seems to be a fair trade-off to make for a tool that streamlines illustrations.
One wild card question advisors should expect from clients is the future of tax rates. In the illustrations above, we assumed there would be a 40% top marginal rate, which seems realistic. That's because in 2011, income tax rates in effect before 2001 spring back into effect in accordance with the Economic Growth and Tax Relief Reconciliation Act of 2001. The top income tax rate returns to 39.6%. With the nation's economic recovery packages costing hundreds of billions of dollars, talk of the need for yet more stimulus, and federal tax rates at an all-time low since the advent of the income tax, the Democratic Congress can do nothing about the tax hike scheduled to take effect after 2010 but allow those higher tax rates established under a Republican administration to take effect. Unless the tax code is totally revamped and a value-added tax (VAT) tax is imposed, most observers expect higher marginal tax rates to be adopted over the next couple of years.
Another wild card could come from a recharacterization of the Roth IRA income. Could Uncle Sam suddenly change its mind about the tax-free status of Roth income? "The likelihood of a complete reversal is very low," says Norquist. "It would be like a bait and switch to the people who have converted, tantamount to breaking a contract with the American people. And, apart from being politically untenable, I wonder whether such a move would even be constitutional."
Norquist cautions, however, that the government could at some point decide that Roth income must be calculated as part of the formula for determining an individual's eligibility for Social Security benefits. Or, he says, perhaps the government could reverse the Roth IRA's exemption from required minimum distributions.
Advisors will likely hear a lot more about tools like Convergent's Roth optimizer in the months ahead. While it does not store cases you've created, it produces PDF reports tailored to each client, enabling you to provide a ten-page takeaway that discloses all of the assumptions made in the calculation. Convergent has also partnered with Advisors Trusted Advisor, a practice management consulting firm, to provide seminar scripts, PowerPoint presentations, and other marketing support for promoting Roth IRA conversion advice for $1,500.
Along with tossing out the old rules, advisors must toss out old tools.
Editor-at-large Andrew Gluck, a veteran financial writer, owns Advisor Products Inc., a marketing technology company serving 1,800 advisory firms.