Roth Conversion Not For Everyone

On January 1, 2010 the income limits for converting a traditional IRA to a Roth IRA were lifted. Three months into the conversion frenzy, advisors are saying deciding whether to convert is more complicated than it seems. The cap prevented households with $100,000 or more in modified adjusted gross income (MAGI) from converting. Now, there is no cap.

On January 1, 2010 the income limits for converting a traditional IRA to a Roth IRA were lifted. Three months into the conversion frenzy, advisors are saying deciding whether to convert is more complicated than it seems. The cap prevented households with $100,000 or more in modified adjusted gross income (MAGI) from converting. Now, there is no cap.

Advisors have been educating and preparing their clients for the elimination of the cap and are now knee-deep in the conversion process. A Fidelity Investment study from January found that 40 percent of investors working with tax advisors were eligible to convert to Roth IRAs up from just 13 percent last year. About 35 percent of those clients are expected to actually complete the conversion by the end of 2010. Converting isn’t for everyone.

Bryan Lee, a CFP who founded Plano, Texas-based Strategic Financial Planning, says deciding whether to convert to a Roth IRA requires a fair amount of due diligence. “It’s not a no-brainer. It has the potential to be a huge tax saver for clients but it’s not for everyone.” Although he’s been communicating about the changes with clients for at least a year now, he says clients need to be shown how they will be personally affected by a conversion. “We show them what their tax liability would be if they choose to do a full conversion, a partial conversation or no conversion at all. It can be a ten minute conversation or a 40 minute conversation depending on the client,” Lee says.

So far, 80 percent of Strategic Financial Planning’s 45 client households have completed the conversion. But there was one client who, after being presented with the different tax liability scenarios, decided to opt against a Roth IRA conversion. (Those who convert their balances must include the amount of their transfer in their taxable income.) Lee says while that client is the exception, it’s important that all the tax liabilities are laid out for each client. “You have to ask, ‘Does the client have the cash to pay the taxes now or will they have to liquidate something else?’ It may not be worth it to convert right now,” Lee says.

Some advisors like Roger Kruse, founding partner at FFP Wealth Management in Coon Rapids, Minn., are extremely cautious of the conversion to the Roth IRA. Kruse believes clients may be in for a significant increase in taxes between 2010 and 2012. “I have a sneaking suspicion that Congress will raise taxes for 2010 retroactively to help pay for some of the deficit and also new programs being approved,” he says. Since the converted Roth IRA amount is taxable income for 2010, an additional retroactive tax in 2010 could push a client’s tax liability over the edge.

Of course, clients who convert to a Roth IRA this year could have the option of reporting half the amount in 2011 and the other half in 2012. But Kruse reminds his clients about a separate tax hike that will take place next year. The George W. Bush income tax breaks for wealthier Americans are set to expire at the end of 2010 which will raise taxes on those making more than $250,000 a year. Those breaks would push the top tax bracket back to 39.6 percent from the present 35 percent. Further, dividends would once again be taxed as ordinary income as opposed to the current 15 percent tax rate today. The capital-gains tax rate would rise back to 20 percent from 15 percent.

All that change in the tax code is enough to make Kruse hesitate before making the Roth conversions. “I hear it all over the place about the benefits of converting. But I think it will be a major mistake for a lot of people if they don’t consider the possible [tax hikes],” he says. For now, he is suggesting that clients wait until the fourth quarter before deciding to convert their traditional IRA into a Roth IRA. He’s waiting to see if there might be a better indication at that point on a possible retroactive tax for 2010. “Just because you can convert right now doesn’t mean you should,” Kruse adds.

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