Doing the Math on Roth IRA Conversions

If you haven’t yet picked a good New Year’s resolution, congratulations, the revised rules for converting IRAs to Roth IRAs have provided a ready-made task for 2010. As of January 1, taxpayers at all wealth levels can convert traditional IRA assets to a Roth IRA.

As The Wall Street Journal commented, “The change — one of the biggest and most important on the IRA landscape in years — will widen the entryway to one of the best deals in retirement planning.”(1)

Like any “best deal,” I hope you will first review the fine print. Yes, the change may offer you important new wealth management opportunities, but it also has become a marketing feeding frenzy, as the many financial product pushers out there realize this may be the chance to attract easy new business by offering to help people with their Roth conversions.

Make no mistake. Opportunities may abound, but so do important caveats. As with any major shift in your strategy, you’ll want to “do the math,” as I like to say, to ensure that all consequences are carefully considered — both the ones that are obvious as well as the ones that require seasoned industry expertise and a deep understanding of your specific wealth profile. Only then can you figure out an equation that sums up well for you.

For an overview of the evolving conversion rules, you can refer to my Fall 2009 newsletter (page 3). The following provides an overview of some of the items I consider under the new rules, when analyzing IRA conversions for my clients. Most issues are covered under these questions:

• Do you have enough wealth to live on without your IRA?
• What are your estate planning needs?
• What are the tax consequences of early conversion?

Do you have enough wealth to live on without your IRA?
(Tax now or tax later?)
As a U.S. citizen obligated to pay income taxes, you are also allowed deductions and exemptions. If you require your IRA assets to support your lifestyle for the remainder of your life, then the distributions you take can or will be offset against these deductions when determining your future taxes. Why would you pay taxes now if, through these deductions, you won’t pay taxes when you take a distribution? That is the question your CPA is going to pose before he or she suggests a conversion. So before you go down this conversion road, you need to do the retirement planning you may have been avoiding since the market meltdown.

What is the appeal of a Roth? Well, for starters, there will be no taxes on any future growth or income and Roth IRAs do not have required minimum distributions. For those who can afford to leave their traditional IRAs to their heirs, they can convert them to Roth IRAs, pay the resulting tax bill, then leave the assets untouched to be passed on without any future taxes on distributions.

What are your estate planning needs?
Will the IRA be left to charity? Donating an IRA to charity is a tax-free event. In this case, it would be imprudent to convert to a Roth because this would create an unnecessary tax bill. This is only one critical example of how your overall estate-planning needs must be taken into consideration as you manage your wealth.

What are the tax consequences of early conversion?
For example, how does your current tax bracket compare with what’s expected in the future? If you expect your tax rate to be lower in the future, which is often the case for older individuals, you may end up paying higher taxes now through a conversion than simply paying taxes later when you receive distributions. On the other hand, if you expect your tax rates to increase which is typically the case for younger individuals, you may see a substantial benefit by paying a lower tax rate now and letting your assets grow tax-free.

I still don’t think any of us predict the future, but doing some math here can be particularly important. Also, an advisor who understands how to maximize allowable recharacterization techniques for structuring your conversion (such as converting into multiple accounts based on asset class exposure), may be able to better effect the most tax-advantaged conversion possible, or perform a timely “undo” if conversion ends up being ill-advised under evolving market conditions.

Have you looked before you leap?
For many, the new rules governing IRA income limits in 2010 represent a window of opportunity. But the conversion decision is not an easy one, as there are many factors to consider. You should work with your wealth advisor and tax experts to determine the tax, estate-planning and overall wealth implications of your decisions.

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Family and Taxes

The first of the summer government holidays is behind us and, if you’re like most Americans, you spent some time with your extended family, creating wonderful memories with those you love. 

 And, if you’re like me, family members each have their opinions about the best way to run our country, fix the economy and take on our future tax burden. Unless Uncle Bob is a tax attorney or Cousin Jane is on the Senate Budget Committee, the debates can veer widely between fact and fantasy.

One of the more hotly debated “facts” thrown around our Memorial Day picnic table was the percentage of taxes paid by the top 5 percent of the wealthiest Americans. Can you guess that figure? According to the IRS, as of year-end 2006 (their most current available data), this group was responsible for paying just over 60 percent of total income tax.  

In April, Senator McCain made the news as he reported his 2006–2007 income taxes. During this two-year period, he paid approximately $157,000 on taxable income of $474,000, or 33 percent, but he declined to disclose his wife’s separate return on her sizeable wealth, citing privacy issues. You can read this New York Times article as one sample. Some point to this and other media coverage to bemoan that “the rich people don’t pay their fair share.”  The top 5 percent paying 60 percent of our taxes seems like a fair share to me, and then some. 

 People who are wealthy are typically wise enough to employ professionals (like me) to help them build their wealth and manage expenses, while remaining adherent to their income tax and other legal obligations. For instance, I advise clients who are in tax brackets higher than 25 percent to seriously consider investing in municipal bonds for the fixed income portion of their portfolio. Muni bonds are not taxed by the Federal government, and can also be exempt from local or state taxes if carefully selected. While helping to minimize a client’s taxes, these bonds support sorely needed financing for local infrastructure such as schools, hospitals, colleges, utilities. These are good things and arguably the reason the resulting income is tax-favored to begin with.

 While I don’t know if the McCains invested in muni bonds, they could have employed numerous other tactics that allowed them to obtain tax credits in a fair and reasonable manner. In fact, according to the same New York Times article, Senator McCain reported $115,000 in untaxed Navy pension during 2006– 2007, i.e., income earned by serving our country.

 Thus untaxed income can be good for America, and it also can be good for creating jobs for advisors like me.

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