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Advisors Owe Clients a Roth IRA Explanation

On January 1, 2010, clients who were previously unable to convert their retirement accounts into Roth IRAs will be allowed to do so thanks to the Pension Protection Act of 2006. But many clients don’t understand what that means for them. Now is the time to make sure they do.

On January 1, 2010, clients who were previously unable to convert their retirement accounts into Roth IRAs will be allowed to do so thanks to the Pension Protection Act of 2006. But many clients don’t understand what that means for them. Now is the time to make sure they do.

Current laws prevent conversions of traditional retirement funds into Roth IRAs for households that have modified adjusted gross income (MAGI) above $100,000. But the Pension Protection Act eliminates that cap, making more households eligible for conversion. Unfortunately, most investors are in the dark about the scheduled changes.

In a Fidelity survey of 800 retirement plan holders with household incomes of $100,000 or more, 83 percent of respondents who work with an advisor said they were unaware that the income limits related to Roth IRA conversions will be lifted next year. Further, more than half of respondents with advisors, or 54 percent, didn't know whether they would be eligible to convert from a traditional IRA to a Roth IRA. “The lack of investor knowledge creates a great opportunity for advisors to educate their clients about the potential benefits of Roth IRAs and help them determine if a conversion is appropriate for their unique situation,” the Fidelity report says.

Roth IRAs allow tax-free accumulation and distribution—unlike traditional IRAs. Contributions and rollovers are not tax-deductible, so clients are taxed when they make the conversion to the Roth. Further, there are fewer limits on withdrawals from a Roth IRA. Withdrawals can be made after the account has been held for five years and when the account holder has turned 59 ½, is disabled, using the withdrawal to buy a first home (with a $10,000 limit) or deceased (beneficiary collects). There is no mandatory withdrawal schedule. Traditional IRAs, by contrast, require owners to take mandatory minimum withdrawals when the account holder turns 70 ½. Withdrawals made before age 59 ½ come with a penalty.

“Considering that a Roth IRA offers tax-free withdrawals and growth potential, analysis done by Fidelity indicates that most investors should consider having one as part of their overall retirement plan to help minimize taxes and maximize retirement savings,” says Chris McDermott, vice president, Fidelity Investments. “We believe if investors have at least 10 years before making withdrawals, anticipate a higher tax rate in retirement or plan to leave savings to heirs, they should consider a conversion.”

Clearly, investors need to understand the tax implications of converting to a Roth IRA first—and they don’t. The Fidelity study found that while 56 percent of respondents felt confident in their understanding of Roth IRAs, 28 percent thought incorrectly that Roth IRA contributions are tax deductible and 20 percent didn't know that investments in a Roth IRA grow tax-free (i.e., capital gains, dividends and interest are not taxed). Further, 66 percent believed withdrawals from a Roth IRA could not be made until age 70 ½, and 70 percent didn’t know contributions to the Roth IRA can continue after that age.

Bob Kresek, founder and managing partner of Founders Financial Network, an RIA in Cupertino, Calif., with about $600 million in assets under management, says many of his clients who qualify for the conversion have done so already. But he’s still having conversations for those clients above the $100,000 income mark. “They aren’t aware yet. Our intent is to have that talk, but it might not be as simple as converting everything into Roth IRAs. We’ve got to get into estate planning conversations, and discuss what the clients want to do with their IRAs,” he says.

A client who wants to give his IRA to a charity might be better off leaving the money in a traditional IRA since charities won’t pay taxes on the withdrawals anyway. Meanwhile, the owner would owe conversion tax if he rolls it into a Roth. “If a client has a big estate and a piece of it is an IRA, he might want to split it into many IRAs, giving one to charity and converting the remainder to a Roth,” Kresek says.

According to the Fidelity survey, just 7 percent of investors intend to convert a traditional IRA to a Roth IRA. About one third of respondents said they don’t understand the conversion’s tax implications and 30 percent don’t understand the Roth’s tax structure at all. Plus, another 30 percent said the balances in their accounts are too small for a conversation, and 27 percent said they lack enough funds to cover the taxes on conversion. For those worried about funding, the government is allowing taxes made on conversions in 2010 to be paid over two years. Anyone who converts later will have to pay the conversion tax in a single year.

Kresek says he expects many of his clients with more than $100,000 in income to convert to Roth IRAs. “I can see some clients getting exciting and converting their whole IRA and be happy to escape future taxes. As long as they are planning to hold onto it long enough and it’s going to their heirs, it works,” he Kresek says.

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