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Retirement planning game-changer: Roth conversions for all

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The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) makes Roth IRA conversions available to all taxpayers, regardless of income.

Now, even high-income taxpayers can take advantage of Roth IRAs. This is a game-changer. TIPRA requires different thinking in the way clients approach retirement. So, here are three retirement planning maxims that merit re-evaluation in light of TIPRA:

Defer taxes whenever possible. Tax-deferral has been a pillar of financial planning and rightly so. In fact, other than tax-deferred retirement accounts and municipal bonds, there have been few alternatives for high-income taxpayers. Roth conversions change that.

Converting assets and paying taxes at today’s historically low rates is a way to diversify retirement account types while hedging against an uncertain tax environment in the future. The conversion of today’s reduced account balances will result in a lower tax liability while giving those assets the opportunity to recover in an income tax-free account. Coincidentally, tax-deferral remains an option on conversions done in 2010, as TIPRA allows conversion income to be spread evenly and taxed in years 2011 and 2012.

Tax liabilities will be lower in retirement. Given the depth of the fiscal crisis, it seems prudent to plan for an increase in income taxes. Rising state and local tax rates also seem inevitable. In addition, depleted retirement accounts will cause many to postpone retirement, work part-time or tap IRAs and 401(k) plans earlier than planned. The combined result will be more taxable income (subject to higher rates) than perhaps was originally anticipated.

Remember that Roth owners are not subject to required minimum distributions, and distributions from the Roth are generally income tax-free. Hence, having the foresight to suggest conversion of assets to a Roth IRA today could make a major difference for clients as they navigate a future retirement made more challenging by expected higher tax rates and the need to work longer.

Healthcare is the greatest expense in retirement. Certainly, healthcare is and will be a major retirement expenditure. But for those in the highest tax brackets, the greatest expense may very well be income taxes. This is compounded when people turn 70 1/2 and then face mandatory withdrawals from traditional IRAs and 401(k) plans. And with tax rates expected to rise, the percentage of retirement expenses represented by income taxes will grow larger.

As volatility and uncertainty buffet the best-laid retirement plans, conversion is a way to establish control in managing income taxes as a retirement expense.

The new rules don’t go into effect until 2010, but it’s not too early to develop a strategy to help clients make informed conversion decisions. Here are some ways to get started:

o Get up to speed on Roth IRAs and the new regulations. As needed, get reacquainted with Roth basics including how pro-rata conversions of deductible and non-deductible assets are handled, the various five-year rules on distributions and recharacterization (undoing the conversion). Keep in mind that partial conversions are allowed, and contributions to a Roth will remain subject to income limits. The special tax-treatment allowed under TIPRA for assets converted in 2010 also merits review.

Then start talking with clients. The early-mover’s advantage goes to advisors who are first in explaining the potential benefits of conversion. Along the way, advisors should consider how a Roth might play a role in their own retirement strategy.

o Find a comprehensive conversion analyzer. Clients will want to know how a conversion can benefit them specifically. Partial conversions will provide advisor and client opportunity to fine-tune strategy customized to needs. A comprehensive analysis will allow for a wide range of scenario planning and include the special tax treatment under TIPRA for conversions done in 2010; it should bring home the benefits of conversion in terms of potential tax savings not only to the Roth owner but also to the non-spousal beneficiary.

o Develop a point of view on asset allocation. The conversion decision is really a two-part question: Should the client convert? If so, how will an income tax-free account affect their overall asset allocation?

The first part is relatively straightforward, based on analysis and the client’s unique circumstances, while the second should trigger an explosion of new and creative thinking on asset allocation. Consider that for many high-income clients, this will be their first opportunity to invest income tax-free without relying on municipal bonds.

It’s truly a brave new world where advisors must come equipped to address the inevitable question of how to invest an account where assets have the potential to be managed for decades in a tax-free environment. Answering the asset allocation question will be a key point of differentiation in successfully retaining and competing for conversion dollars.

The time to start clients planning is now as advisors look for practical and actionable strategies to address today’s unprecedented market conditions.

TIPRA is reason to reengage with those high-income clients by challenging the traditional rules of retirement, legacy planning and asset allocation. As such, advisors and clients alike will be well-served by evaluating the potential benefits of a Roth IRA conversion.

Kevin O’Fee is vice president-innovation for Lincoln Financial Group, in the Radnor, Pa. office. His e-mail address is [email protected].


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