Roth apathy is the real gamble

In his Other Voices article “Roth conversions: The gamble of a lifetime” (InvestmentNews, Feb. 1) Andrew Rice raises several concerns about advisers’ and clients’ rushing headlong into a Roth conversion without stopping to consider the potential downside. He also expresses concern that many financial professionals are recommending Roth IRA conversions for the purpose of generating sales versus doing what is in the client’s best long-term interests. These are both valid concerns that warrant industry scrutiny.

However, Mr. Rice makes several other arguments that should not go unchallenged. So in the interest of balancing the scales, I will revisit several propositions from his article.

John F. Kennedy once said: “There are risks and costs to a program of action, but they are far less than the long-range risks and costs of comfortable inaction.” While one can legitimately argue whether the risks of a Roth conversion are greater or less than the risks associated with not converting, at the end of the day, one simple fact remains: Ignoring the Roth conversion opportunity altogether (true inaction) is not a risk-free proposition.

Mr. Rice wrote: “If your client has a $500,000 [traditional individual retirement account] and a marginal tax rate of 25%, roughly $125,000 of the $500,000 is government-leveraged tax dollars. If we assume it earns 10% on the $500,000 each year, your client is actually leveraging $125,000 in government tax dollars to make more money. For every dollar earned on the leveraged tax dollar, the client with a marginal tax rate of 25% keeps 75%. So the question becomes: “Would your client rather have the investing power of an IRA worth $500,000 or a Roth IRA worth $375,000?’ I think clients and financial professionals alike will agree on the answer.”

No, they will not.

In assuming that the $500,000 traditional IRA in his example is inherently better than the $375,000 Roth IRA, Mr. Rice makes a common mistake. His argument is valid when comparing tax-deferred savings to taxable savings but mathematically invalid when comparing tax-deferred savings with tax-free savings. To the surprise of many, the $375,000 Roth IRA is mathematically equivalent to the $500,000 traditional IRA if we assume that the IRA owner’s tax rate in retirement is the same as his tax rate at the time of conversion — and ignore the fact that Roth IRA savings are exempt from mandatory distributions for the life of the IRA owner (which, of course, favors the Roth IRA in cases where the IRA owner is able to take advantage of delayed distributions).

What’s more, comparing a $375,000 Roth IRA with a $500,000 traditional IRA ignores the fact that clients with available outside resources can leverage non-tax-sheltered assets to pay the taxes on a Roth conversion — in which case the magnitude of the additional leverage potentially gained is dependent on the opportunity cost associated with the accelerated expenditure of the outside assets.

Mr. Rice goes on to address the effects that a Roth IRA conversion can have on a client’s future tax deductions. He stated: “All future income from a Roth used by your clients to make charitable contributions, pay medical bills, long-term-care expenses, mortgage interest or property tax does not receive the same marginal tax deduction as does income received from a [traditional] IRA.”

First, we note that the value of a tax deduction is not directly tied to the source of income from which the payment is physically made (this would be akin to saying that I cannot deduct my church offering because I made the donation from my long-term savings, and not from my taxable wages). Second, taken literally, this argument seems to say that future taxable distributions from a traditional IRA may subject clients to a higher marginal tax bracket — and that this is good because then the client’s future tax deductions will be worth more.

Mr. Rice added: “Basically, future tax savings with an IRA are negated once the Roth IRA conversion takes place, because the client paid all taxes upfront.”

Apparently, tax-free growth does not technically qualify as “tax savings” in his lexicon.

Toward the end of his article, Mr. Rice touched on the estate-planning implications associated with Roth conversions. He astutely pointed out that a Roth IRA conversion can backfire if the IRA owner’s intent is to leave an IRA nest egg to a tax-exempt entity such as a charity or if the next-generation beneficiary is likely to be in a much lower tax bracket than the original IRA owner.

Again, these are both legitimate caveats, and ones which all advisers and estate planners should carefully consider when weighing the potential pros and cons of a Roth conversion.

Mr. Rice continued by stating that “a grandchild beneficiary stretch [traditional] IRA could be more advantageous than a Roth, as the stretch IRA allows longer tax-deferred growth.”

This is simply not true. Ironically, the Roth IRA is the quintessential “stretch” IRA, as it allows non-spouse beneficiaries the same opportunity as the traditional IRA beneficiaries have to stretch the distributions out over the beneficiary’s life expectancy, but it also provides “bonus stretch” by allowing the original IRA owner and his or her spouse to avoid mandatory distributions completely during their own lifetimes.

THREE IMPORTANT CONSIDERATIONS

While there are myriad considerations that deserve shelf space when considering the Roth IRA conversion question, I have found three considerations to be of fundamental importance:

• Expectations about future tax rates.

• Ability to leverage outside (i.e., non-IRA) assets for conversion taxes.

• Ability to take advantage of required-minimum-distribution delay or avoidance.

The impact of each of these factors — in isolation — is easy to understand and appreciate. However, it is the complex interrelationship of these factors that makes Roth conversion analysis so dynamic and helps to ensure that overly simplistic rules of thumb will fall short of capturing the true essence of the Roth conversion conundrum.

For dyed-in-the-wool Roth cynics, the ultimate concern is often expressed in the form of a question: “How likely is it that the government is going to allow Roth IRAs to accumulate and distribute tax-free growth as designed?” While no one can answer this question with 100% certainty, my guess is that the likelihood is “somewhat north” of what the Roth cynics would have you believe. Nonetheless, it’s a legitimate question that needs to be asked. As an industry, however, we must not fall prey to the tendencies of the cynics, who prefer to treat this as a rhetorical question rather than the legitimate question that it is.

Perhaps the best way to close a discussion such as this is by simply laying down the gauntlet. For advisers and their clients, making a fully informed, balanced decision not to convert to a Roth IRA is — unequivocally — a legitimate choice. But ignoring the Roth conversion opportunity altogether — whether out of ignorance or apathy — is, quite frankly, unconscionable.

Ben Norquist is president and CEO of Convergent Retirement Plan Solutions LLC.

Related Topics: ING Group