Although the Roth conversion isn't for everyone, financial advisers must have the conversion conversation with every client who qualifies. If you aren't discussing conversion now, you can bet that some other adviser is.
In helping clients decide whether to convert assets from a regular individual retirement account to a Roth IRA, advisers should keep in mind that this year may be the last opportunity to reduce taxes on the conversion. Roth conversions can still be done after this year, but at what cost?
Taxes for many clients may be higher. Advisers must identify those clients who will benefit most from a 2010 Roth conversion and take action now to plan out the most efficient and low-cost Roth conversion possible.
Three questions must be part of every Roth conversion conversation:
When will you need the money? If the client needs access to the converted funds soon after the conversion, they probably shouldn't convert. But for wealthier clients who won't need the money now (or ever) and have sufficient funds to pay the tax, a Roth conversion may make sense, especially if it's being done for estate-planning purposes.
In fact, if there is one group for which a Roth conversion would almost always pay, it is those doing it for estate-planning purposes.
What do you think future tax rates will be? If you think that future tax rates will be higher, then it pays to take advantage of the low tax rates that expire at year-end.
Conversations about future tax rates also must take into account the behavior of beneficiaries. If you think that their tax rates will be lower, a Roth conversion might be inappropriate, especially if there are several beneficiaries.
Remember that under our graduated tax rate system, a person who reports $300,000 in income (all other factors being equal) will always pay more in tax than three people who each report $100,000 in income.
For example, if Tom has a large individual retirement account and has named his three children as his co-beneficiaries, each child will receive one-third of the required minimum distribution after Tom's death. Each child could pay less tax than Tom would have, especially if Tom sets up his IRA on the assumption that the children will be in lower tax brackets.
Not only might Tom's children be in lower brackets, but the RMD income will be split over three tax returns, further reducing the overall tax that the beneficiaries might pay.
If Tom tells you that his children may not stretch the inherited IRA because they need the cash or are spendthrifts (and Tom doesn't want to set up a trust to make sure the stretch IRA is maintained after death), then it might not pay to convert. The power of the Roth IRA is free compounding over time.
The more time, the better. If beneficiaries are going to withdraw the funds soon after death, a Roth conversion becomes more costly and less effective.
Of course, if Tom doesn't convert, then he will be subject to RMDs once he reaches 701/2, triggering taxes at whatever bracket Tom will be in. If Tom thinks that he will be in a lower tax bracket at that point, it again may not pay to convert.
Where will the money come from to pay the tax on the Roth conversion? If the client can't pay the tax on a conversion from non-retirement assets, he or she probably shouldn't convert. You don't want to go broke converting.
Remember, though, a Roth conversion isn't an all-or-nothing proposition. Partial conversions can be done and should be considered.
Wealthier clients with IRAs or company plan funds not only qualify for a Roth conversion but also generally have the money to pay the tax on the conversion from outside funds.
These wealthy folks know about the presumed federal tax increases and that when state taxes are added, their marginal rates could rise above 50%.
They (or their beneficiaries) don't want to lose half their money to taxes when they have an opportunity to do something about it now.
Many wealthy clients look at the expected tax hikes as a money problem.
To their minds: “If you have the money, there is no problem.”
Because they have the money, the Roth conversion at today's lower tax rates is a no-brainer, allowing them to buy their way out of the problem now and forever.
Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.
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