For your baby boomer clients, the ability to convert pre-tax assets in a traditional IRA to a tax-free Roth IRA is an opportunity they don't want to miss. Even if you've already broached the subject, it's worth revisiting for several reasons.
One of the most important factors in evaluating the benefits of a conversion is the client's current income tax bracket compared to what it will be when they retire and start withdrawals. As you know, the converted amount must be declared as income in the year of the conversion. If a client anticipates their income tax bracket will be lower at retirement, then paying tax at their current rate might not make a lot of sense.
However, given the amount of debt the federal government has taken on recently, your clients may be expecting tax rates to be headed higher. If that's the case, then they're better off converting now and "locking in" today's rate. In addition, they will avoid income tax on all future gains (assuming they meet the five-year test when they withdraw from it).
Even if a client has no idea what their tax rate will be when they retire (who really does?), you can respond by asking, "Well, wouldn't it give you peace of mind if the rate you'll pay on some of your retirement income could be zero?"
Of course, they must still meet the income requirement. Until Jan. 1, 2010, when the income limit on Roth conversions is permanently eliminated, the only taxpayers eligible for a Roth conversion are those whose modified adjusted gross income is $100,000 or less, whether they file "married/joint" or "single." Those who file "married filing separately" cannot convert at all until 2010. Individuals who convert IRA assets in 2010 (only) will have the special option to pay the full amount of the tax when they file their 2010 income tax return, or to defer payment of the tax until they file their returns for 2011 and 2012. Individuals who choose the latter will add 50 percent of the converted amount to their taxable income in each year.
The silver lining of the sell-off in the financial markets is that the tax bill for investors converting their traditional IRAs to Roth IRAs may be less. That's because the value of the assets in their traditional IRA has probably declined.
Since the goal is to get as much money as possible moved into the tax-free Roth IRA, ideally, individuals should use non-IRA money to cover their tax bill. One strategy would be to sell taxable investments that are worth less than the client paid. This generates a capital loss that can be used to possibly offset some of the income tax associated with the conversion.
Advisors often ask, "How do I know if a Roth IRA makes sense for a particular client?" Frankly, you can't be certain. In addition to future income tax rates, there are many other unknown variables, such as: Will the individual need to take withdrawals from the Roth IRA to supplement their retirement income? If so, when would they start? What return will the investments in their Roth IRA generate? Do they wish to leave some or all of their IRA to a beneficiary, particularly a young one?
My response is simple: Everyone should consider a Roth. Remind your boomer clients that the reason you diversified their investments was because it's impossible to know which asset class will out-perform in a given year. Likewise, since there's no way to predict what income tax rates will be in the future, it's important to diversify their portfolio from a tax perspective. This entails owning taxable, pre-tax and tax-free assets. Explain the benefit this way, "No matter what the tax rates are when you retire, we'll have the flexibility to choose which type of account to pull income from so that we can minimize the tax consequences for you." Clients will not only understand this, they'll appreciate you.
Gail Buckner, CFP, AIF is a retirement and financial planning specialist for Franklin Templeton Investments, and an instructor for Franklin Templeton Academy, the company's global financial advisor training program.