May 7, 2010

Weekend interview: Phil Demuth, advisor and bestselling author, on why Roth conversions are falling flat

It was supposed to be the perfect confluence of events. Tax law changes embedded in the Tax Increase Prevention and Reconciliation Act of 2005 lifted income restrictions on those converting from Traditional IRAs to Roth IRAs in 2010. For clients hesitant about the initial tax hit, the law allowed for payments to be smoothed over years 2010 and 2011. And because of poor global economic conditions, many traditional IRAs plummeted in value, further decreasing any associated tax and clearing the way for a tax-free Roth rebound.

The opportunity for advisors from investors chomping at the bit was to be immense; a whole new area of expertise that would further diversify and increase the advisor's suite of services.

Yet a survey from Putman Investments released last week found only 14% of respondents were considering converting some or all of their traditional IRA assets to a Roth IRA either this year or next, with a majority (56%) saying they definitely would not convert.

So what happened?

Phil Demuth has the answer. The co-author of eight New York Times bestsellers on planning and investing (along with economist, lawyer and comedian Ben Stein), he manages $100 million for 50 high-net-worth clients with a minimum investment requirement of $1 million. And did we mention his Ph.D? He and Stein's latest is The Little Book of Bulletproof Investing: Do's and Don'ts to Protect Your Financial Life.

Boomer Market Advisor (BMA): Why didn't the rate of Roth conversions happen as predicted?

Phil Demuth: In a phrase--legislative risk. Clients are very suspicious of the government's intentions. They feel it's too easy for politicians to go back on their word. They give money to the government in the form of taxes due upon conversion, and essentially get an IOU for a promised future tax break.

BMA: And those IOUs won't hold?

PD: They write a check today for a hamburger Tuesday? No, they're just not believing it. Just look at what's happening. With the current level of public spending, tax increases will have to come from somewhere. And we're in an anti-high-net-worth environment.

BMA: You advise high-net-worth clients. What are you telling them?

PD: I advise them to see if a Roth conversion makes sense financially. If they believe it does, we sit down and take a look at the bigger picture. We consider the market environment, the political environment and the tax environment now and where we believe it is going to be in the near future. The conversion doesn't have a lot of appeal for the high-net-worth set.

BMA: So lifting income limits wasn't such a great selling point. What about for mass-affluent or middle market?

PD: It does have more appeal for those making, say, $200,000 or under. If you have $20,000 in a traditional IRA that you'd like to convert, it makes much more sense. But that was true before these government incentives took hold. There's certainly more political will to protect those making less than $200,000 than the high-net-worth, so there's less legislative risk in that sense. For the clients I deal with, the lifting of the income caps didn't make much of a difference. The trust is just not there.

BMA: But the Obama Administration has made incentives to save for retirement a priority. Why are clients concerned about Roths, specifically?

PD: There's precedent here. A lawyer friend of mine recently reminded me of a "high achievers" tax supplement initially included in IRA legislation when Reagan introduced them in the early 1980s. It's great if the promises come true, but with what the Obama Administration has already said about those making over $250,000, they have reason to be skeptical. Even if what eventually happens doesn't come directly from the government reneging on Roth promises, there are many other ways they could do so.

John Sullivan is editor-in-chief of Boomer Market Advisor and AdvisorBiz.com, part of Summit Business Media's Advisor Media Group.

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