Roth conversions: The gamble of a lifetime

Many investors approaching retirement view the stock market as too much of a gamble. They’ve been told so many times that the market is just too risky and that fixed-income investments or a guaranteed annuity are all they need. I don’t agree with that advice, but most investors make their decisions based on perception rather than reality.

In discussing perception versus reality, let’s put aside retirement investment strategies for another time and address what I believe to be the biggest current “gamble of a lifetime,” the 2010 Roth IRA conversion.

This conversion has turned into one of the largest new-business campaigns for financial sales representatives that I’ve seen in all my years of advising clients.

In a nutshell, while excluding most of the technical issues and the reversal provision, the law allows all traditional IRA owners to convert 100% of their IRA to a Roth IRA starting in the year 2010, without income limits or marriage status requirements.

If converted in 2010, the income taxes due on it may be paid in 2010 or split between 2011 and 2012. Once an account is converted to a Roth IRA, you pay no income taxes in future years; the money is completely tax-free (if qualified) for life. On the surface, that sounds great, but let’s look a little deeper.

WHAT’S THE HURRY?

There’s an old saying that the only sure things in life are death and taxes. As most investors are in no hurry to die, why would they be in a hurry to pay all of their IRA taxes upfront?

More importantly, why would a financial professional recommend this conversion, based only on the assumptions that tax rates will forever increase, Roth IRA tax laws will never change, and that it’s better for clients to have a converted Roth IRA than their current IRA?

I wonder if advisers who believe those assumptions to be true ever consider additional factors, such as the effects of their clients’ future deductions for charity, medical expenses such as long-term care, mortgage interest, property taxes, tax credits or even the effects of their clients’ overall estate-planning objectives? This conversion goes deeper than just the tax consequences of today. It affects later years when there are children and even grandchildren to consider.

Let’s analyze the basic assumptions:

• Will tax rates increase forever? The highest U.S. marginal tax rate has changed 36 times between 1913 and 2010, ranging from 7% to 94%. That range supports the case that tax rates could be higher in the future, but also indicates that tax rates could be lower in the future.

•Will Roth IRA tax laws ever change?

No one can answer that question with certainty, but if Congress can change the tax rates 36 times in nearly 100 years, why assume that it will never change the Roth IRA’s tax-free status?

• A converted Roth IRA is better than a traditional IRA.

Let’s compare the benefits of an ordinary IRA with those of the Roth. An IRA allows your client to leverage his or her government tax dollars in order to make money over a lifetime. For example: If your client has a $500,000 IRA and a marginal tax bracket of 25%, roughly $125,000 of the $500,000 is government-leveraged tax dollars. If we then 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 that answer.

There are some further points to consider:

• The effects on your client’s future charitable, medical, long-term care, mortgage interest and/or property tax deductions, and/or any future tax credits.

You may be wondering what these issues have to do with the Roth IRA conversion. When income is received from an IRA, it’s subject to taxation. However, when income is received from a Roth IRA it is not subject to taxation. Therefore, 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 an IRA. Nor does the client receive income from tax credits. Basically, future tax savings with an IRA are negated once the Roth IRA conversion takes place, because the client paid all taxes upfront.

• The effects on your client’s overall estate-planning objectives. What are the primary objectives of your client’s estate plan? If he or she wants to leave money to charity, the Roth IRA conversion would be a complete mistake. Your client would be better leaving the balance of their IRA to charity, resulting in no income tax, as charities have tax-exempt status. Do your clients want to leave money to grandchildren for education? If so, a grandchild beneficiary stretch IRA could be more advantageous than a Roth, as the stretch IRA allows longer tax-deferred growth. Also, required distributions are based on the grandchild’s life expectancy, and tax is paid at his or her immediate tax rate, which is usually a much lower bracket.

• The fact that the U.S. tax system is a progressive system and not a flat-tax or regressive system.

Realize that a Roth conversion results in relinquishing control of the client’s money to the government once it receives that tax check. Clients can then only hope that the government will never want more.

Why is the government allowing this unlimited conversion opportunity in the first place? Perhaps it needs more money because of the astronomical U.S. debt. If that’s the case, remind your clients that they can send the government an extra check at any time, without converting anything.

IRAS AND MEDICAL EXPENSES

While I believe these are valid arguments against conversion, the major reason to have an IRA versus a Roth IRA is a client’s future need for medical expenses, long-term- care or assisted-living coverage. The following personal example further illustrates this point.

I have an elderly client who was forced to move into a long-term-care facility. I had to ramp up his income withdrawals to pay for his LTC costs, as well as his other needs. I recommended that we make all of his income withdrawals from his IRA. Previously, his income came from both IRA and non-qualified assets in order to manage his total tax situation better.

My reason for changing all his income withdrawals to his IRA was due to the known future medical expenses he would have at the LTC facility. I was able to arrange for him to use tax-deferred money instead of after-tax money to pay for those expenses. The actual medical deductions resulted in his paying roughly just 2% in taxes on all of his income.

The advantages that the client and his family continue to realize from designating his income source as an IRA instead of a Roth are immeasurable. He got the benefit of contributing to the IRA at a 25% tax rate, and now he’s paying an effective 2% tax rate. That’s a 23% tax savings for the client instead of the government, not counting the IRA’s earnings over the last 25 years.

The same example can also be viewed as the partial funding from government tax dollars of the client’s LTC expenses. If you look at the same example, my client got the benefit of paying only 2% in taxes, meaning the government paid roughly 23% toward his LTC bills.

When explained to clients and their families, that analysis is very comforting, as most investment clients would never be eligible for Medicaid coverage for long-term care. Under this scenario, the client is still better off with an IRA instead of a Roth IRA.

I believe that the reason many financial professionals are recommending this conversion is salesdriven, rather than what’s in the client’s best long-term interests.

As a fiduciary, I cannot recommend that my clients take this gamble, as there are just too many unknown variables. In my view, there are only a few cases where this gamble may be worth it. For the vast majority of clients, it’s not.

Andrew D. Rice is vice president of Money Management Services Inc., an independent registered investment advisory firm.