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 AdvisorOne.com will be working with fi360 on the Call for Papers for 2011, 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
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
It's also critical to compare apples to apples in any analysis. I believe it's inappropriate for supporters of the conversion to recommend that a client take outside investable assets and use those to pay the tax bill, just to get the benefit of future tax-free growth on a separate pot of money. They further validate this assessment by presenting a simplified conversion calculation of the growth between a $500,000 IRA and a $500,000 converted Roth. In order to factually apply what most conversion experts are recommending, you have to compare the $500,000 IRA to a converted $375,000 Roth, net of the assumed 25% tax rate, and then answer the following questions to thoroughly project whether the future tax-free growth is really worth the conversion:
- How long will it take for the tax-free Roth to make up the difference of forfeited taxes, paid up front, when assessing the "lost opportunity cost" of future tax-leveraged earnings, which would have been generated from all the tax dollars if left in the converted IRA?
- Moreover, has the "lost opportunity cost" associated with having the proposed outside assets as after-tax investments been considered? The client had to pay taxes on that money at some point in the past, and now some are recommending clients exchange those assets as tax deposits just so they can have tax-deferred assets become tax-free assets.
- Granted, required minimum distributions are made from an IRA and not a Roth, but to be fair to the equation, did you reinvest the net after-tax income from the IRA distribution in an after-tax account to balance the equation, when assuming no distributions from the Roth during this same timeframe?
- Have you included a client's income needs from an IRA without also applying the same income needs against the Roth?
- Are you able to accurately predict each client's individual, spousal, child and grandchild's specific tax and income situations, year-by-year, over the next 50 to 100 years?
- Do you have factual information on what our country's tax laws will look like year by year over the next 50 to 100 years?
Lastly, many colleagues are recommending a partial conversion option to balance a client's complete financial position between after-tax assets and taxable assets. While I definitely see a more reasonably calculated gamble with a partial conversion versus the full conversion, I still have a few concerns about this approach. Based on current IRA laws, a client turning age 70-1/2 has to start required minimum distributions (RMD) from their IRA account. When looking at required minimum distributions from a slightly different perspective, one could argue that the client is already being forced to make small partial conversions each year after age 70-1/2, just in a different form.
While you can't convert RMDs to a Roth, you can reinvest the net after-tax distribution into an after-tax account, assuming the client doesn't need the income. I realize this isn't exactly the same as a Roth's future tax-free growth; however, you don't have to deal with the five-year Roth holding rule after conversion. The after-tax account would pay taxes based on dividends and capital gains, which are only 15% if properly tax-managed, whereas with a Roth, you wouldn't. However, on the flipside, an after-tax account would allow a tax-deduction for realized capital losses, whereas a Roth doesn't. Also, an after-tax account could take a stepped-up basis to the fair market value at the date of death, depending on the total inherited assets at the time of death, which could involve some form of tax-free gain similar to a converted Roth.
So, when considering the assessment that a partial Roth conversion could be somewhat similar to an RMD, does your client really need to partially convert at all?
Obviously, the conversion issue is a very comprehensive situation with many unknown variables involved both now and in the future. Lacking a crystal ball, my question is, "What's the big rush, since the law now allows Roth conversions in any year going forward?" Having an IRA still allows your client to make a conversion decision at any time, but a 100%- converted Roth completely cements the client's position (once past the allotted reversal period), leaving them with few other options. In my view, the conversion still remains "the gamble of a lifetime."