The debate goes on: To Roth or not to Roth?

The following is an edited transcript of an InvestmentNews.com webcast held in New York on March 9. Moderators were InvestmentNews deputy editors Evan Cooper and Frederick P. Gabriel Jr. Panelists were Ed Slott and David B. Loeper. To listen to the archive of the webcast, visit Investmentnews.com/rothtranscript and click “View archive.”

InvestmentNews: Ed, you’ve been a proponent of Roth conversions for quite some time. Overall, do you still think it makes sense to convert?

Mr. Slott: It’s one of the biggest practice-building opportunities for any adviser right now, and any adviser that’s not addressing this is making a huge mistake.

I’m not necessarily saying to do a Roth or not to do a Roth, but remember, in 2010, every client with a 401(k), a 403(b), an [individual retirement account], any sort of retirement account like that that has an eligible rollover distribution is a Roth conversion candidate, regardless of income. So this opens the floodgates for Roth conversions, and if your clients aren’t getting this information from you, chances are, they’re getting it from somewhere else, because they’re all interested.

Most people are worried about what’s going on in the government — probably see tax rates’ going much higher. I believe tax rates will go through the roof, just taking into account everything that’s going on. But here’s the big opportunity for advisers: As the president said, there’s a deficit of trust among clients who are unhappy and looking for advisers who can give them this type of advice. The floodgates are open.

And another important point is that the floodgates are open for a whole new crowd of clients — high-net-worth, high-income clients who never qualified for a Roth before, and those people are looking for advice on whether to convert or not. And I think that’s probably a place to start.

People with the largest IRAs are probably the best candidates for a conversion for estate-planning reasons if they have the money to pay the tax. They don’t need the money for a long time; that’s a key.

Need is a key requirement, not so much age. For example, someone converting after the age of 70 years is not converting for himself or herself, because the cost versus the benefit in the life expectancy is probably not worth it; they’re probably converting for the next generation or for grandchildren.

For estate-planning purposes — if you don’t need the money and you want to pass it on — it’s almost a slam-dunk, especially if you have clients like mine who are over 701/2 and hate required distributions. All of my clients who are taking required distributions are being forced to take money they don’t need, pay tax on it and add it to their existing income. So now all the other items on their tax return start to cost more. They start to phase out their exemptions, deductions, credits — all the tax benefits that tend to phase out when your income increases.

The thing those clients like about a Roth conversion is that once you pay the tax, Roth IRAs have no required minimum distributions. Once the conversion is done, the people who don’t need the money can just let that Roth IRA grow for the rest of their lives. And if they have a spouse, they can leave it to the spouse, who can also roll it over to his or her own Roth IRA and let that grow for years uneroded by taxes. Then it will pass to beneficiaries — at some point, it’s going to pass to a non-spouse beneficiary — and they will have to take required minimum distributions, but only after the death of the Roth IRA owner and the spouse if the spouse is the beneficiary. And even then, the required distributions they take will be tax-free.

Since conversions are a great way to transfer wealth, especially if the client doesn’t need the money, many wealthy or high-income people who didn’t qualify before are looking for this information now. And the more money a person has, the more they hate taxes. That’s just the golden rule. They see what’s going on and realize that they’re going to be hit with any tax increases first, and it might pay to bite the bullet now at relatively low rates. I believe we’re in probably the lowest tax rates we’ll ever see in our lifetime, just looking historically. And values are relatively low. So it’s almost a double sale on Roth IRAs — rates are low, and values are low.

And I’m not talking about values’ being low because of the stock market — they are low because of that; some of them are still depressed — but low in relation to the values that they will be in 20, 30 or 40 years with growth that will never be taxed again.

I would also target people who have named a trust as their IRA beneficiary. Most people who have named a trust probably did it because they had large IRAs worth, say, $5 million or $10 million. The reason somebody names a trust is because they don’t want a $5 million IRA going to a 16-year-old.

Now, with a traditional IRA, when the required minimum distributions go to the trust after death, they may end up getting trapped, and a lot of these trusts are discretionary trusts where the trustee has discretion and may not pay out the required amount to the trust beneficiaries and accumulate the funds in the trust. Well, when that happens, they get hit with the highest tax rates in the land, trust tax rates, and that’s a big hit. For example, in 2010, an individual wouldn’t hit the top rate, 35%, until taxable income exceeds $373,650, but a trust hits that rate after just $11,200 of income. So most trusts are going to get walloped with taxes under that scenario.

A great planning move for these people would be to convert their IRA now to a Roth IRA. They probably couldn’t before, because of the income limits. I would say to those people, especially if that IRA’s going to a trust and you’re going to lose, say, 40% a year just in accumulations in a trust, [that] you make that a Roth IRA. Yes, there are required distributions after death, but the accumulations will not be taxed in the trust, because Roth IRA distributions after death will be tax-free. It removes the trust tax problem, and a lot of these people can’t stand that extra tax hit.

There’s one group on the estate-planning side where I think it really pays — those who don’t need the money, have the money to pay the tax and want to pass funds over to their children or grandchildren income-tax-free. A conversion also reduces their estate because if they convert, say, a $10 million IRA and they end up paying, say, $3 to $4 million of tax, that tax reduces their estate as well, so less money will be taken in estate tax, whatever that tax will be.

That’s one group that I think is a slam-dunk on the Roth conversion.

InvestmentNews: Dave, what makes sense and what doesn’t make sense about Roth conversions?

Mr. Loeper: I’d agree with Ed that it’s a slam-dunk if all your clients are people who have money coming out of their ears that they have no use for, and regardless of what the markets do in the future, you know that they’re going to have plenty of resources. It’s also a slam-dunk if all your clients are worried about estate issues.

But I’m not sure such people represent the preponderance of the client base of most advisers. And there’s a lot of uncertainty about what most people have to deal with.

Future income tax [rates] likely will be higher; I think that’s a pretty common consensus. A lot of times, we look at it from the perspective of somebody who’s young, [for whom] compounding over many years will make up for the immediate tax bite. We had already mentioned how people hate the costly RMDs that are associated with tax-deferred accounts. Beneficiaries, as Ed mentioned, might be in a position to have very high ordinary income tax rates applied to the benefits that they get. After all, the government has been very good to us over its entire existence, and it’s going to honor its promise for tax-free treatment forever, and there’s no chance of that ever being repealed.

InvestmentNews: Hmm, sounds like a little sarcasm there.

Mr. Loeper: We know how much it will cost to convert — that’s certainly something you can calculate — and we have the ability to model what the future values and goals of the client will be, so the question you have to ask yourself is: Of these things that are Roth benefits, which are certain, and which have some uncertainty?

The only thing we really know with certainty is what the costs are today. Future income tax rates might change, tax-free compounding over many years may not be a benefit, and all the other things are subject to some amount of uncertainty. Now, how much that all adds up to be depends on the unique client case, and every client is completely unique.

If you care about your clients, you have to be really careful about the assumptions that go into these analyses.

You should be particularly wary of an analysis of conversion in isolation of other goals and other assets or those that assume that the client is going to be in the exact same tax bracket and pay the same rate every year for the rest of his or her life. There’s no chance of that occurring, and you shouldn’t rely on a tool that’s assuming that. Also, avoid any tool that’s ignoring the risks and excesses of extreme markets — the markets are highly uncertain, and they always are, despite what many people might say. And then, also, just looking at everything from a marginal tax rate, because the reality is, [if] you’ve got somebody who has a $100,000 required minimum distribution coming out and they’ve got an $80,000 spending need, it’s not all going to be taxed at the marginal rate; their effective rate’s going to be much lower.

So you should take a step back and objectively understand, first, that the decision to convert an IRA — and again, I’m not talking about somebody who is deciding between an after-tax decision to go to an IRA or an after-tax decision to go to a Roth; in that case, it’s a no-brainer, go for the option of getting tax-free — means that you’re with certainty paying a tax now that you have the choice to avoid.

Now, that could certainly make sense, but there’s some hope associated with that. You would do that under the assumption that markets are going to treat you well enough that you wouldn’t need that money at some later date. Once you give the money to the government, you have no chance of getting it back.

Also, while we’re all looking at this assumption that tax rates are certain to go higher, there are some things like the fair tax — in essence a national sales tax — being discussed and getting some momentum. In 1999, when Clinton was in office, you would have never guessed that we’d be paying low capital gains rates on dividends from stocks. So it’s an erroneous assumption to say that there’s no chance that such changes can occur.

I am just a little bit suspicious that Capitol Hill wouldn’t be tempted to cease the tax-exempt status when there are thousands of millionaires that are not paying any taxes.

InvestmentNews: Dave, let’s look at the case study you provided about a couple in Virginia.

Mr. Loeper: I chose Virginia because that’s where I live, and it has a moderate state income tax rate.

And this might be somewhat typical of a fairly common client. They’re 66 years old, they’ve got $1 million in IRAs and $378,000 in taxable assets — which is about the amount of the tax bill in connection with converting the IRA to a Roth.

The couple has a lifestyle need of being able to spend $90,000 a year net after taxes, adjusted for inflation. They are fortunate enough to be on a government pension, from which they’re getting $75,000 a year in non-inflation-adjusted pension benefits.

They have an estate goal of leaving behind $1 million. We’re going to plan on a life expectancy of 96, which is the 80% percentile of the spouse. We’re going to use a 60/40 allocation, which is our balanced allocation. We’re going to assume 1% advisory fees and investment expenses combined, 20% annual turnover, and then on any taxable assets that might exist, we’re going to realize 80% of the gains as long-term.

Most important, when we run the Monte Carlo simulation on this, we’re going to calculate dynamic taxes. That means that for this 30-year plan, we’re going to calculate 30,000 tax returns, 1,000 simulations, and each year, we’re going to calculate what the taxes would be in each individual year, based on forced RMDs, based on market behavior and all that stuff, which is much more realistic than assuming a fixed rate.

As for the confidence level — and this is not considering what beneficiaries would have to pay — we see that the regular IRA actually has 82% confidence versus 73% for the Roth, but of course, taxes are still owed on the portion that’s left in the IRA.

InvestmentNews: What does 82% confidence versus 73% mean?

Mr. Loeper: The percentage of the trials that exceeded that $1 million estate goal and provide the $90,000 net inflation-adjusted spending need after tax.

And of course, any Monte Carlo simulation you run is only as good as the assumptions that go into it. This is based off of our capital market assumptions.

If you don’t like our capital market assumptions, I reran the analysis using 637 historical 30 year periods, and it happened to be the same intersection for probability for the Roth conversion.

I’ve taken the Roth conversion percentile outcomes distributions versus the regular IRA, and RMDs are indeed going to create some taxation, and force some excess money beyond the spending desires and spending goals of the client. And we see throughout the distribution, there’s a fair amount in taxable assets that end up getting distributed at low confidence levels. As we start going down through the distribution towards higher confidence levels; even at the 75th percentile, we see some taxable assets.

Now, we don’t know what the beneficiaries’ tax rates will be, but I can back in to calculate the tax rates that are needed to be at parity with the certainty of writing that check for $380,000 to the government in 2010 or 2011 that I don’t have to do and I have the option to do later if I’m making so much money that I don’t need it.

It’s very unlikely that the government is going to have a negative tax rate, like the fifth and zero percentile; your beneficiaries are not going to get your IRA assets and on top of that get a contribution from the government. So clearly, if you’re in very, very positive markets for this client’s set of goals, there’s a huge benefit of it. It’s also very unlikely that your beneficiaries are going to be at a 7.88% tax rate.

Understand that all those benefits, though, were at three to 28 times the goal that the client actually had. When you start working towards the middle of the distribution and downward, you discover that the tax rates have to be pretty darn high to make writing a check this year to the government make sense. At the 75th percentile, the beneficiaries would have to be at almost a 62% tax rate, and even at the median, at the 50th percentile, they’d have to be at a 34% — not marginal but blended — tax rate. And once again, here you’re at a goal that is already at two times the goal that they wanted to leave behind.

The one problem in all this analysis is the assumption that the plan is never going to change.

The odds are very high that the plan indeed is going to need to change. In fact, in the course of the next five years, there’s about a 68% chance that the plan will either become overfunded or underfunded, drifting into needless sacrifice. If the client’s got an extra $1 million or $2 million around, they might change their goals. Similarly, if they become underfunded, their goals might change too. We would argue that it should be your job to keep the client on track and adequately funded for the goals they personally value, and what choices they have amongst those goals.

But even if tax rates and goals were knowable in advance with certainty, just the market uncertainty alone means that conversion may be highly advantageous or merely a push or fairly detrimental — all depending on how bad the markets are.

The biggest Roth advantage usually exists when outcomes far exceed the goals that any client might have in really outstanding markets. For many, I would argue that there’s no need to rush to write that check. You can convert later, when some of the uncertainty of time has passed. You don’t want to be in a position of regretting having written that giant check and then having a need for that money.

InvestmentNews: So in essence, what you’re saying is that maybe it’s not such a great idea for most moderately wealthy people to convert or, at best, to just wait a while and see if conversion makes sense. Ed, how do you respond to that?

Mr. Slott: I do a lot of consumer seminars, and it seems that the people who come out for these events, especially now, are those who have $1 million or more in an IRA. There are a lot more of them out there than most people think, and maybe I tend to attract them.

But one of the misconceptions that most people have is that it’s all or nothing. People say, “Should I convert or shouldn’t I?” Well, a lot of people might be in the middle somewhere and should do partial conversions.

It’s important for advisers to mention that to clients: You don’t have to convert everything, even this year. Yes, it’s true; whatever you convert this year gives you a two-year deal, which lets you hold on to money for quite a long time. You include half the conversion income in 2011, the other half in 2012.

Mr. Loeper: At higher tax rates in 2012.

Mr. Slott: Right.

Mr. Loeper: It’s not really free financing. The government is mortgaging future tax revenue to get [revenue] now. And they’re making it sound like it’s free financing for half the tax bill, but they’re going to make up more than they’re paying on government bonds when the new tax rates kick in next year.

InvestmentNews: Ed, what are the other benefits to converting all or in part now?

Mr. Slott: Well, the other thing David pointed out, which I agree with, is that clients approaching age 701/2 will be forced to take this money anyway — maybe not as much. But the problem with required minimum distributions, you almost can’t change your mind at that point, because required minimum distributions cannot be converted. And some clients aren’t aware of that, even now, for a couple of reasons: First, they just don’t know the rule exists, and second, required minimum distributions for 2009 were waived, but they’re back now. So you still see some clients that want to convert now and convert it all after 701/2.

So once they hit 701/2, they have to first take their required distribution — and they can’t convert that money — so then if they want to convert, they actually have to take more money out to convert. So a lot of them should really look at this decision before hitting 701/2. In the 60s is a sweet spot for this, just looking ahead, that you’re going to be forced to take this money at higher rates anyway.

But the partial conversion is not a bad way to hedge your bets. You know, do a little in “10, “11 and “12, and little by little, get something into tax-free territory.

InvestmentNews: Wouldn’t this be something you would want to ease clients into? Ed, even your very wealthy clients probably would rather not go through all this and then have you say, “Oh, by the way, before you leave, you have to cut a check for $3 million.”

Mr. Slott: Well, yeah, it’s a lot of money, but you can actually work the estimated tax rules and the two-year deal to hold on to your money for a long time.

For example, let’s say you converted in January or do so now; you really don’t have to come up with any money for that conversion until April 15, 2012. You can hold on to your money for over two years, so whatever you earn on that, it’s like the government’s giving everybody — for a limited time — an interest-free loan to build a tax-free savings account. And as David said, yes, the rates kick in at “11 and “12, but you really don’t have to start paying the estimates. By April 15, 2012, you’ll owe the tax bill on the first half in “11, and then you’ll get into regular estimates for the next year. But you’re really holding on to a lot of that money for longer than most people think.

InvestmentNews: If a client decides to go the partial route, what would be the best way to approach it? What assets do you convert first?

Mr. Slott: What David said is right; it’s a client-by-client scenario.

Again, I go back to my three core questions: When, what and where? When do you think you’re going to need that money? If the client needs the money within five years of conversion, then generally they are not a conversion candidate. In fact, if they’re already thinking about when they can spend it, conversion is not for them. The power of the Roth is in the long-term tax-free compounding.

The “what” concerns what they think future tax rates will be. If they truly are convinced that they’ll be taxed at a lower rate in retirement, then conversion is not for them.

And finally, there’s the where — meaning: Where will the money come from to pay the tax? Nobody should go broke converting, so that’s where partial conversion comes in.

Then there are other items on a tax return to consider. I had one large client who lost a bundle to [Bernard] Madoff. Thanks to new rules that allow the deduction of those Madoff losses, my client — who still has $6 million in an IRA that [Mr.] Madoff didn’t get his hands on — can convert that money tax-free because of the losses he is able to deduct.

That’s an extreme situation, of course, but many other people have had a rough time, such as businesspeople who have had losses in their S [corporations], who may have situations that can reduce the cost of conversion. Again, that’s where partials may come in.

Another great thing to remember is the Roth re-characterization, which lets you undo any change. Anyone who converts this year has all the way up to Oct. 15, 2011, to change their mind for any reason at all and re-characterize or reverse all or part of the conversion to bring it right back to the point where you pay the lowest amount of tax.

For example, if any of someone’s 15% tax bracket is going unused, you should be able to throw in at least enough Roth conversion income to use up the bracket allowance, because it’s really a bargain.

InvestmentNews: David, tell us how you think advisers should approach partial conversions in terms of which assets go first. What would you do? How would you handle it?

Mr. Loeper: If you take a look at the [case study] analysis [available at InvestmentNews.com/rothira], we could have analyzed converting half of it. But all that would have done — throughout the probability distribution — would be to have lowered, at the fifth and 25th percentile, for example, the effective negative tax rate that they have to have if the markets are zooming. It would have been a bit more detrimental than it would have needed to have been at the 75th or 95th percentile, so there was a cost to it. And there is cost. There’s a lot of uncertainty that you’re dealing with.

Now, that’s not to say that I’m always against conversion or partial conversion; I’m not at all. But there are other things you can do to impact your tax bite — for example, putting your fixed-income investments in your tax-deferred accounts that will be subject to [taxation as] ordinary income, whether they’re in your taxable account or tax-deferred. Plus, in theory at least, because we normally assume equity returns are going to be higher, that will minimize the amount of RMDs that you’re going to be forced to make in future years.

So here’s my advice: Put your equities in your taxable accounts, where you can at least get favorable capital gains treatment, even though the dividend treatment’s going away.

I would definitely concur that if a client faces a reasonable probability of being forced into excess RMDs, taking advantage of making withdrawals from taxable accounts to support a lifestyle need now, in doing a conversion, a partial conversion, to capitalize on a 15% tax rate, then it makes sense again.

In each client case, therefore, it’s always a matter of minimizing taxes that you can avoid with certainty and exploiting low tax rates, as well as tax location benefits for asset classes — something you can also control. I can’t control what future tax rates are going to be, though.

Mr. Slott: And that’s one of the benefits of a Roth. You’re using known values.

One thing that the conversion does is remove the uncertainty of what future tax rates will be. I mean, whatever you’re paying now, it’s a known value, and that’s why a lot of these calculators that people are using really don’t help until you have better numbers, because the biggest input item is future tax rates. I have people who get their own solution by putting in a low tax rate and then say, “Oh, maybe I shouldn’t convert.” Other times, they put in a high tax rate and say, “Oh, I had better convert.” So you won’t have those numbers.

The best way to do it, like I said before, is probably try a conversion now; you really have nothing to lose, because it can be re-characterized up to Oct. 15, 2011. That’s over a year away, so by that time, you’ll have more-accurate numbers.

Maybe there’s potential appreciation that happens right now in the Roth. Let’s say you have $100,000, and by Oct. 15, it’s up to $150,000; you still only owe tax on the $100,000.

InvestmentNews: David, are Financeware clients asking about how to make the conversion decision?

Mr. Loeper: I’m really surprised at how much common sense most people have. I think most of the clients recognize that there’s not really a rush to do it; they’ve got a free option to do it sometime in the future. If I say, “I’ve run the analysis, and it doesn’t make sense for you to write a big check,” that’s what they wanted to hear. And for the goals that they value, it is oftentimes the right decision.

InvestmentNews: Aren’t these a hard sell for advisers? If clients walk into an adviser’s office and are told all about this Roth conversion, they’ll think the adviser looks pretty smart. But as soon as they are told to cut a check for $30,000, they’ll think the adviser looks a little less smart.

Mr. Slott: I would never say it’s a hard sell, because it shouldn’t be any sell. You know, the adviser’s neutral on this. The adviser doesn’t get a cut of everybody who does a Roth.

But I’ve got to tell you, on the other side, I have clients who know that they might have to write a check now, but what they get for that, their future tax rate, at least on Roths, will be 0%. You can’t beat a 0% tax rate.

Mr. Loeper: The tools that a lot of advisers are using are assuming certainty about something that’s uncertain.

InvestmentNews: Speaking of tools, David, could you identify some tools that might be helpful?

Mr. Loeper: No commercials here, but I haven’t seen one that I would trust for an analysis.

People are confused; they don’t know what the answer is. What the industry is doing — and Wall Street has a reputation for this — is exploiting action. They want movement, and they can exploit action and get movement by creating misleading tools that cause action. Whether that action is in the client’s best interest or not is highly in doubt, but there are many tools that can make very convincing presentations to get people to part with their money, and that’s what a lot of the industry is about, unfortunately.

Mr. Slott: Roth conversion discussions should be done as a service to clients, and maybe even to prospect for new clients, but based on good information that you’re going to do an analysis and address that to the benefit of the client.

There are those clients who just don’t want to have to pay any tax when they’re in their 70s or 80s; maybe they’re retired and don’t have income coming in. That’s the last time they want to have to suffer maybe a higher rate, and some of them are willing to pay some money now [in order to avoid that].

InvestmentNews: Aside from converting existing IRAs to a Roth, will you discuss the strategy of making non-deductible traditional IRA contributions and then converting those to a Roth?

Mr. Slott: To me, that’s a no-brainer. I did that myself. I put $6,000 in a non-deductible IRA and converted it to a Roth. To me, that’s just moving the money from one pocket to the other, and it’s tax-free in the other pocket. There’s absolutely no cost to doing that.

Mr. Loeper: If you’re going to pay taxes on the additional amount, it’s a no-brainer to stick it in a Roth or use a Roth 401(k). However, if you’re not maximizing what you can deduct, it all depends on your individual situation. In a paper I wrote on this topic, I gave an example of a 30-year-old who will not be in a particularly high or particularly low tax bracket in retirement, but [considering] the lifestyle cost of making a non-deductible contribution when he could avoid taxation and have more money working tax-deferred, it was actually beneficial for him to not make a Roth contribution. So it depends on the client.

In general, things that you can control with certainty, like not paying taxes now, is something that you should not ignore and just not jump on the bandwagon because some tool was designed to generate action.

Mr. Slott: For most clients, David’s argument makes sense if that extra savings is invested, but most clients, you know, while you’re doing their taxes, they’re talking about where they’re going to spend the refund. So most of that money that’s generated by the extra deduction is spent, and if it’s spent, to me, it’s wasted in that analysis.

InvestmentNews: Do you have any other thoughts on anything we’ve said thus far? Is there anything you want to add that we didn’t cover?

Mr. Slott: We talked about a no-brainer for estate planning, but I also think it’s a no-brainer for very young people. They have very small IRAs, very low tax brackets, or they’re just starting out. It’s very good to start out with Roth IRAs [because of] compounding over time. The greatest moneymaking asset anyone can posses is time. I did it for my own daughters as teenagers, opened Roth IRAs. It’s a great thing to mention to clients for their kids and grandkids if they have a little side income on a job. You know, that really adds up over time.