Will higher-income investors be prepared when they get a green light two years from now to convert traditional IRAs to Roth IRAs for the first time?
There may be no free ride when it comes to investing, but with Roth IRAs there are tax-free qualified distributions, earnings, capital gains and dividends throughout an investor's life. The only problem with Roth IRAs? Contributions are not allowed for people who exceed adjusted gross income limitations. For 2007 a married couple filing a joint federal income tax return could make a full contribution (up to $4,000 each, $5,000 for people over 50) if their AGI was less than $156,000 and a partial contribution if AGI was more than that but under $166,000. Single filers could make a full contribution if AGI was less than $99,000 and a partial contribution if it was more but under $114,000.

But starting in 2010, anyone, regardless of income, can convert his or her traditional IRA to a Roth IRA. The looming Roth opportunity is big news for higher-income investors, who have been shut out of the investment vehicle and its tax-free gains and distributions and advantageous estate planning characteristics since its creation in the last decade. The icing on the cupcake is even richer for investors who make the switch to a Roth in 2010, since Congress is giving them two years to pay the income tax bill generated by the conversion.

"This is a fantastic opportunity for our high-income and high-net-worth clients," says Marjorie L. Fox, principal and CEO of Fox, Joss & Yankee, an advisory firm in Reston, Va. Fox estimates that the firm's 200 clients may convert as much as $10 million. "We like to be proactive, so we're encouraging clients to start thinking now about what accounts they want to convert, so they're prepared two years from now."

Fox, whose firm manages $250 million, is also being proactive when it comes to helping clients plan for the income taxes the conversion will cost investors. "We're just beginning the conversation with most clients now," Fox says. "We would like clients to be able to pay the taxes with funds outside their IRAs, so we need to start planning for that. We're finding that clients are very receptive."

Besides the tax advantages, the estate planning benefits of Roths have become legendary at this point. Not only do investors not have to take required minimum distributions at age 70½-as they do from traditional IRAs and other qualified plans-but heirs and beneficiaries are given preferred tax treatment. While those who inherit a Roth must begin to take required minimum distributions based on their own life expectancy, the distributions are tax-free.

Roth investors don't have to take required minimum distributions, so if they have other income options they don't have to take withdrawals in years like this one, when the markets are down. On the other hand, in some instances Roth withdrawals do make sense. "While we often approach Roth IRAs as a 'next-gen' estate planning tool-and [as] money clients want to earmark for their heirs-in some scenarios, if the markets are down or it doesn't make sense to take capital gains, having a Roth IRA to tap gives investors a needed option," Fox says.

Of course, while the Roth conversion presents a great opportunity for affluent investors in 2010, it could still lead to unforeseen costs and consequences. The chief concern is that Congress will renege and make Roths taxable in the future. "I guess that's the worst-case scenario," Fox says. "You pay income taxes to convert to a Roth IRA starting in 2010 and then it's not entirely tax-free. That's why we like to have a straightforward conversation with clients about possible risks. We don't want them blindsided."

While much of the conversion action will come from traditional IRAs, investors will also be able to transfer 401(k)s, provided the retirement plans are custodied in former employers' plans or in SEP or Simple IRAs. The Pension Protection Act of 2006 allowed investors to do a direct conversion from a qualified retirement plan into a Roth beginning in January 2008, eliminating the need to transfer the 401(k) funds into a traditional IRA first. Now, because the income limits on transfers and conversions to Roths will be lifted starting in 2010, anyone can transfer their 401(k) to a Roth IRA beginning that year, says Cathy Pareto, president of Cathy Pareto & Associates, a registered investment advisor firm in Coral Gables, Fla. "In my experience, 80% of the people I work with leave their old 401(k) plans in place until we start working with them. Rare is the occasion that I meet with someone who doesn't have a plan sitting some place. I just did a piece in our client newsletter on orphan 401(k)s. I'm a big proponent of getting the money out of limited, often expensive plans and into a rollover IRA. Now we're preparing clients for 2010, when they'll be able to use a Roth."

The overall discussion of the merits of conversion is a smart one, as is one about the fluidity of tax rates. "What if an investor converted to a Roth in 2010, and took two years to pay and then Congress changed the tax rates starting in 2011?" asks Louis B. Llanes, president of Blythe Lane Investment Management, Greenwood Village, Colo.

While many affluent investors believe their income will be the same in retirement as it is now or even greater, it pays to think about whether that will really be the case before converting to a Roth and paying income taxes on the conversion, Llanes says.

But if tax rates do go up, a person whose distributions came only from qualified plans would face income tax on all that cash flow. Using Roth IRAs for some part of future distributions will result in lower income and Social Security tax payments, as well as Medicare co-payments.

"I think the question for clients is always, Will my tax rates go up going forward?" says Llanes. "Should I pay my taxes now or later? Given the fact that there will be a lot more need for entitlement spending in the years ahead, I'd rather pay my taxes in two years than in 15 years."

Investment professionals who specialize in IRAs are rubbing their hands together with glee over the Roth opportunities on the horizon. "The big deal to me is higher-income folks haven't had access to Roths before," says Jaime Raskulinecz, chief executive officer of Entrust Northeast LLC in Verona, N.J., whose company acts as a custodian and consultant to investors interested in creating self-directed IRAs, which give them the flexibility to invest in real estate and a broad range of alternative investments generally not available from a broker-dealer.

Higher-income folks have little if anything in Roths currently. Wealthy individuals found that their income exceeded the IRS' household income caps, so they couldn't contribute or convert.  "Now, we're hearing clients making plans to convert to Roths," says Raskulinecz.

Unlike 401(k) plans, IRAs allow direct investment in real estate and some individuals who are planning to convert are interested in that option. Raskulinecz says she is working with one client who is eyeing the purchase of waterfront property. By converting her old 401(k)s and traditional IRAs to a Roth in 2011, the 40-year-old client will have enough funds to purchase property, build on it and rent it out until she's ready to retire after age 59½. "Presumably, she'll pay a lot less to purchase and build her dream vacation home at 40 than she would at age 59½, and any gain will be tax-free because of the Roth," Raskulinecz adds. "Our clients like the investment flexibility and the complete tax savings." And just imagine never having to pay gains on highly appreciated real estate again.

What about all those investors who are self-employed and have created and funded their own SEP-IRAs or profit-sharing plans? In many instances, some or all of the balances in those accounts can be converted to a Roth IRA, even if the investor is still self-employed and saving for retirement.
"I don't think this is on the radar screen yet for everyone, and that's a mistake for both investors and advisors," says Gail Buckner, a retirement specialist with Franklin Templeton. While higher-income investors will be able to make conversions from 2010 onward, the two-year window to pay income taxes is only available to investors who convert to a Roth in that year. "I think everyone has to start planning from an asset and tax perspective starting now," Buckner says. "Some people's tax bills will be significant even if they're broken down into two years, and it helps if they start setting aside funds now."

Buckner, who is also an instructor at Franklin Templeton Academy, says that future tax rates should figure prominently in investors' deliberations on whether to convert. "I believe, looking at Washington, that there is a good chance that rates will go up, especially for high-net-income folks. I certainly don't think rates will come down."

At the very least, investors should diversify their portfolio so they have a hedge if they need one if ordinary income tax rates climb significantly in the years ahead. "Just like you diversify an investment portfolio, it pays to diversify your investments from a tax perspective as well," Buckner says.