Reasons Not to Perform a Roth Conversion

I love Roth IRAs. I love the concept of growing assets income, tax-free and moving the asset through the estate without built-in income tax. I also love the flexibility for IRA owners with respect to Required Minimum Distributions (RMD). They are not required to withdraw money every year at age 70 1/2. The RMD does not start until the IRA is designated as an “inherited” IRA (meaning a non-spouse inherited the IRA or a spouse chose not to re-title / rollover the IRA to her own).

• Planning Note - Roth 401(k) / 403(b)s are required to take RMDs (unless you’re still working for the employer and less than a 5% owner), simply rolling those monies into a Roth IRA will remove this requirement

What I don’t love is when Roth IRAs are being spammed to every individual who has an IRA regardless of circumstance. Roth IRAs should be positioned as planning tools, which encompasses every unique situation. They are not one-size-fits-all tools. If the Roth is not appropriate, you should position yourself as the expert to explain why it is not appropriate.

I often am asked about my opinion on Roth carve-outs. This refers to funding the IRA with a bonus (enhancement) annuity or product and using that bonus to pay the tax on a partial conversion. I have seen illustrative software on this specifically from other institutions. What they fail to look at, is the opportunity cost of the monies that are used to pay the tax vs. using outside money.

• Planning Note – When converting to a Roth, if the money is paid out of the IRA itself, the benefit or detriment is determined solely on tax rates at conversion versus tax rates at distribution. If tax rates are the same, the conversion is a wash, regardless of rate of return or deferral time.

Please see my former blog entry about how paying tax from outside the IRA works in “Converting Roth Rumor to Truth”.

To compound on this issue, many people perform conversions and pay from within the account, then immediately draw income. This can be a major detriment because they are withdrawing money from a lower account value (increasing the percentage withdrawal) and depleting the asset faster.

Paying from inside the IRA, or using this carve-out methodology works if the client does not want to touch the money, they don’t want to take RMDs, and they expect the tax rates to be higher upon distribution (an effective tax hedge).

So as you can see, the conversion proposal should not be applied to every situation.

• Planning Note – If a qualifying charity is the beneficiary of an IRA, there is no need to convert to a Roth as the charity will already be afforded tax-exempt status on the IRA income passed to them.

There are different types of conversions, what we have just discussed is a possible “hedge conversion”, but it does not apply to every individual and the tax should still be paid from outside the IRA if possible.

With that being said, practitioners will need to take a close look at how to treat the 2010 conversions based on next year’s tax rates. With continuing discussions on tax rates and the Bush tax cuts, you may want to opt out of the 2-year deferral.

• Planning Note – If tax rates are higher in 2011 and 2012 than what you would pay for a conversion in 2010, you can opt out of the income deferral and pay for the tax this year. Ask your tax practitioner to take a look at which method is most advantageous.
• Special Planning Note - Two married spouses who both convert their IRAs in 2010 can opt for different treatment. One can opt for the 2 year deferral while the other opts to take the income in 2010. This essentially creates a 3 year spread of income (not necessarily proportionally).

I will hit on specific Roth topics throughout the year, with increased activity towards the end of 2010 as legislation becomes more clear and clients see their 2010 window shrink. Remember however, that window is only for the 2 year deferral, not for conversions as a whole. Everyone is allowed to convert their eligible retirement accounts to Roth IRAs.

There is even talk about pushing through allowed procedures to internally convert a traditional 401(k) into a Roth 401(k).