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.