Editor’s Note: Andrew Rice won the fi360 Call for Papers -2009 with an article cautioning advisors about Roth IRA conversions, “The Gamble of a Lifetime” (InvestmentNews, February 1, 2010). As there is more to say on this topic, and as WealthManagerWeb.com will be working with fi360 on the Call for Papers for the upcoming year, we are happy to publish Andy’s additional work on this subject. Our focus as always, is: what is in the client’s best interest?–Kate McBride
By Andrew D. Rice
In a previous article, I couldn’t tackle all the issues associated with this complicated conversion dilemma, nor can I completely finish them here. However, I’d like to propose a number of additional issues worth considering, based on feedback to my original article, in the hope that it, as well as other discussions, will prompt advisors to step back and at least re-think their opinions on the Roth very carefully.
From my perspective, most recommendations for conversion are not completely and factually accurate. Therefore, I offer these additional thoughts that should also be taken into consideration when considering a Roth conversion for a client:
1. Know that Roth conversion calculators can provide inaccurate analysis
2. Compare apples to apples when doing the analysis
3. Realize required minimum distributions could be viewed as a different type of partial conversion
Let’s look at these more closely:
One assumption used in some online Roth conversion calculators is that outside assets are available for a 100% conversion in order to pay the tax bill. My issue with this comparison is that instead of only comparing the two assets of discussion (IRA money converted to Roth IRA money), some calculators incorrectly slant the presentation by assuming that tax dollars owed for the conversion are paid with outside assets, instead of assets from within the IRA. This slants the presentation unless both sides of the future projected comparison are balanced. If one assumes outside assets will be used to pay the conversion taxes, the comparison of the non-converted IRA has to have the outside assets remain as an addition to a client’s complete portfolio value. You can’t use one pot of money on one side of the equation, and then exclude it from the other side in the future projection comparison.
Some online conversion calculators do try to accommodate this point, but in what I believe to be an inefficient manner. They assume earnings on the outside assets are taxed annually at a user-defined future tax rate, which is also the same future tax rate applied to traditional IRA distributions. In reality, those outside assets, depending on the type of after-tax money, could pay taxes at many different rates such as dividend tax rates, short-term capital gain rates, long-term capital gain tax rates, or ordinary income tax rates.
When further analyzing the application of the future tax rate, it’s inaccurate to assume the highest tax rate for the options above, as it slants the opinion toward converting. As we know, qualified dividends and long-term capital gains are currently taxed at a
maximum of 15%. In addition, consider that if those outside assets are invested in tax-exempt bonds, there may be no taxation at all (excluding capital gains and alternative minimum tax). Therefore, many of the most comprehensive conversion calculators inaccurately assume higher taxes on outside assets, which in turn, decreases the future projected value of those assets when presented as a comparison.
Apples to Apples