Wealthy investors seen reluctant to rush into Roth IRA conversions

Mutual fund companies are reporting a brisk business in Roth IRA conversions as a result of a change in the tax law, but there is one segment of the public that is decidedly cool to the idea, even though their financial advisers are urging them to take the plunge.

Wealth advisers said that a lot of their clients, many of whom would benefit the most from an IRA conversion, are rejecting their recommendation to convert their traditional individual retirement accounts or old 401(k) plans to Roth IRAs, because they don’t want to write a fat check to Uncle Sam.

Taxpayers who earn more than $100,000 annually this year for the first time became eligible to convert to Roth IRAs. Unlike regular IRAs or 401(k) plans, in which taxes are paid when the money is withdrawn, withdrawals from Roth IRAs are tax-free.

Among fund companies, The Vanguard Group Inc. reported 33,000 conversions, and Fidelity Investments 22,000, in January alone (InvestmentNews, March 1).

But to make the conversion, taxpayers have to pay the Internal Revenue Service tax on the amount being converted at their ordinary income tax rate. While middle-income taxpayers with a moderate amount of money in their IRAs may not mind paying the tax, higher-income taxpayers apparently do.

For example, a person with a $1 million IRA who is in the 35% tax bracket may have to write a check for $350,000, assuming that they convert the whole amount into a Roth IRA. That becomes a sticking point for many wealthy clients.

“Do I think it’s better for a lot of clients?” said Doug Flynn, co-founder of Flynn Zito Capital Management LLC, which has $250 million under management. “I do. The problem is getting people to part with the tax money.” Only a “handful” of the firm’s 100 clients have taken advantage so far, Mr. Flynn said.

Christopher Cordaro, chief investment officer at RegentAtlantic Capital LLC, which manages $1.8 billion, identified 20 of his 100 clients as being good candidates for conversion, but so far, only one has actually gone through with the process.

Roth conversions, Mr. Cordaro quipped, are turning out to be “the best planning idea that will never happen.”

“It sounds appealing, but in the end, clients have to write a check,” said Leo Marzen, principal at Bridgewater Advisors Inc., which oversees about $825 million. “They say, “Hmm, that’s a big number.’”

Generally, advisers’ wealthiest clients would benefit most from the conversion, as they generally have the largest IRAs, and they can pay the taxes due without taking any money from retirement accounts or scrimping on living expenses. Advisers also consider the age of the client and how the retirement account would be used, whether for living expenses or for estate planning.

Some of the bestfit clients are those who want to use the Roth for estate planning, advisers noted. These clients are well-suited because distributions are not mandatory after a client reaches 701/2 , and distributions to an heir may be tax-free if all requirements are met. It’s always vital that a client talk to his or her accountant to make sure tax implications are fully understood, advisers stress.

Wealth advisers have been poring over their client accounts to see which ones should take advantage of the IRA conversion.

“This has taken a lot of time,” Mr. Cordaro said. “It’s probably added an extra 3,000 or 4,000 hours of work since the end of last year.”

At least his firm hasn’t taken the expected hit to assets and revenue that he anticipated.

At the beginning of the year, Mr. Cordaro expected clients to withdraw about $20 million in assets to meet IRS obligations — at a loss of $200,000 in revenue to his firm. But conscientiousness forced Mr. Cordaro to accept that outcome.

Given their fiduciary responsibilities, even when a client says no to a Roth, many advisers try to keep the issue on the table. Clients still have several options to take advantage of the opportunity.

“When folks say, “I don’t want to pay today,’ I probe further,” said Tom Kelley, a senior financial planner at Wilmington Trust Corp., which manages $42 billion. Mr. Kelley talks clients through the possibility of doing a partial conversion or paying the taxes due over two years or — if the client worries that he or she will really start to suffer from buyer’s remorse — undoing the whole thing.

Anyone who does a conversion this year, Mr. Kelley pointed out, will have until Oct. 15 next year to undo it, if an extension is filed this year.

Then, even if the client completely balks after considering all the options, there’s always next year, Mr. Kelley said. “We’ll bring it up again next year.”

Lynn Miori, who is an accountant and a wealth manager at KMH Wealth Management LLC, which manages $134 million, said none of her 166 clients has done the conversion yet, but she’s working with them in laying out all the possibilities and parameters.

“Clients seem to understand it more once you lay it all out in a spreadsheet,” she said.

E-mail Hilary Johnson at [email protected].