Convert to a Roth? Decision depends on many unknowns

To deal with the “Roth revolution” that starts next year, advisers’ best tool may be a crystal ball.

Any decision to convert wealthy clients’ traditional individual retirement accounts into Roth IRA in 2010 involves assessing current and possible future tax rates, forecasts of investment performance and strategies for estate planning, experts say.

The most immediate concern, according to tax specialists who say they are working overtime on Roth conversion number-crunching scenarios, is the wild-card question of where income taxes on the rich are headed over the next few years.

“Lots and lots of people are talking about doing Roth conversions next year, blindly thinking they’ll still be in a 35% tax bracket, but with the conversion income and potential tax increases, you could end up in a 50% or 60% tax bracket next year,” said Herbert Daroff, a tax attorney with Baystate Financial Planning, a $6 billion advisory firm.

The 2010 rule change, which was part of the Tax Increase Prevention and Reconciliation Act of 2005, lifts the ban on Roth IRA conversions for people with adjusted gross incomes of more than $100,000.

Those opting to convert qualified-retirement-plan assets to a Roth IRA next year will have to pay taxes on the converted assets, which could add up to a short-term windfall for cash-strapped government budgets.

In order to encourage the tax-generating activity, the rule includes an option to pay taxes on the 2010 conversion by April 15, 2011, or spread the tax bill over the 2011 and 2012 tax years.

The rule change subjects high earners to the same dilemma faced by many of their lower-paid peers for years: Roth or traditional IRA?

Financial advisers and tax-planning specialists are quickly realizing the new wrinkles that will accompany the Roth option for many of their clients.

“There is no blanket statement you can use to say if converting to a Roth is right or wrong for everyone, you just have to make your best guesstimate of where you expect taxes to be down the road after running multiple models of each client’s situation,” said Steve Bigge, a tax manager at Baker Tilly Virchow Krause LLP.

For wealthier clients, a major appeal of converting traditional retirement account assets to a Roth is that there are no minimum-distribution requirements until at least a year after the primary account holder and his or her spouse dies.

This could make the Roth IRA a valuable estate-planning tool for clients who can afford to leave the money in the account for their heirs.

“The conversion is a great strategy for the client who doesn’t think they’ll ever need to take money out of the IRA to cover living expenses,” said David Polstra, a partner at advisory firm Brightworth Wealth Counsel.

“To me, the Roth conversion makes the most sense for high-net-worth clients who have the bulk of their assets outside of a retirement account,” he added.

The challenge facing most advisers with regard to the Roth conversion debate is deciding when and how to manage the taxable event that is triggered when moving assets from a traditional IRA to a Roth.

Most advisers discourage conversions whenever the client doesn’t have enough money outside of the retirement account to pay the taxes.

Beyond that, the question gets more complex and requires trying to anticipate the direction of income taxes on the rich, which is something the Obama administration has honed in on.

“I’m concerned we’re heading into a much higher income tax environment, so I’m advising clients to convert early next year before the account values go up,” Baystate Financial Planning’s Mr. Daroff said.

However, he added, converting early still might not protect investors from higher taxes that could be introduced after the 2010 elections. Those taxes could be applied retroactively to the start of the next year.

One factor that might encourage some clients to pay all the conversion taxes in 2010 is the January 2011 expiration of the Bush administration’s tax cuts, which will bump the top tax bracket to 39.6%.

“All things being equal, you would opt to pay the taxes on the conversion over two years, but all things are not equal,” said Martin Silfen, a wealth planner with Brown Brothers Harriman & Co.

“You have to remember, you’re not paying half the taxes; you’re declaring half the income from the conversion, and a lot of people believe income tax rates are going to be higher,” he added.

Even though the rule change has been on the books since 2005, advisers should expect a flood of inquiries throughout next year.

According to a September survey of high-income Americans conducted by The Charles Schwab Corp., 61% of respondents were unaware of the pending Roth conversion option.

Of those respondents familiar with the conversion opportunity, 26% characterized it as being more confusing than health care reform.

Of the 400 respondents, 71% said they are likely to consult with a financial adviser for direction.

One side effect of the new Roth conversion option is it leaves open the opportunity for Roth contributions beyond next year.

While high-income clients are still prohibited from directly funding a Roth, the new rule would allow them to fund a traditional IRA and then convert to a Roth annually.

“It’s a glitch in the law as far as I can tell, because there will be an indirect way of funding a Roth, regardless of your income,” Brown Brothers’ Mr. Silfen said.

E-mail Jeff Benjamin at [email protected].