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Financial Planning > Tax Planning > Tax Deductions

Why Not Do a Roth Conversion?

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New tax laws for 2010 removed the income cap for IRA-to-Roth IRA conversions, presenting financial advisors and their clients with an interesting opportunity for investing in Roth IRAs. Although there are obvious advantages to having a Roth IRA, including tax-deferred growth and tax-free qualified distributions, a Roth conversion may not be in the best interest of every client.

Questions to Weigh

One question to consider when deciding whether to do a Roth conversion is whether or not the client anticipates being in a higher tax bracket in retirement than at the time of conversion. Given mounting budget deficits, federal and state income tax levels may increase. However, taxpayers can lower their tax bracket by taking a portion of their living expenses from taxable accounts, tax-deferred accounts and contributions to Roth IRAs.

In some cases, taxpayers will have high itemized deductions during retirement. They may be able to take an amount from a qualified account that deductions and exemptions will offset. By taking additional amounts to satisfy living expenses from the taxable accounts or Roth IRAs, they could eliminate or greatly reduce their tax liability. Clients who have accumulated significant assets with different tax characteristics will have the most flexibility to reduce their tax liability during retirement.

In cases where clients’ only retirement assets are in qualified accounts, it is reasonable to assume that they will spend all their assets during retirement. Accelerating the tax liability, by converting to a Roth, may not be in their best interest.

This is especially true if there is a short time between paying the taxes on conversion and needing the money for spending. For clients who are nearing retirement, paying taxes now may be a disadvantage even if their tax brackets gradually go up over time. Clients who only have assets in qualified accounts may not have the funds available to pay for the liability, which would cause a 10% penalty if they are taking funds from the converted IRA to pay the taxes prior to age 59 1/2 .

Also, if the client will need to access the money within the next 5 years, a Roth conversion may not in their best interest. The client cannot access the money in the Roth IRA for 5 years from the beginning of the year in which the Roth IRA is established, even if they are over 59 1/2 at the time of withdrawal.

There is much talk about the ability to spread the tax liability for Roth conversion in 2010 by including 50% of the conversion amount in 2011 and 50% in 2012. This sounds like a great idea under the premise of deferring income as long as possible; however, with the tax brackets potentially increasing, this can work against clients if you find them in a higher tax bracket in either of those years.

Clients can defer a decision on whether to pay the tax over 2011 and 2012 by requesting an extension when filing the 2010 return. That will allow them to wait and see what the tax brackets will look like in 2011. If the taxes will be higher in 2011, it may be best to include the entire amount of the conversion on the 2010 tax return.

In all cases, taxpayers must be aware of what a conversion will do to their income tax withholding requirements and whether or not they are meeting their safe harbor withholding and if paying estimated taxes are necessary. Taxpayers may have to increase withholding on their paychecks or pay estimated taxes to meet the withholding requirements, rather than deferring the problem until the tax liability is due.

Beyond federal taxes, one must consider the state income tax implications of conversions. Some states tax distributions from IRAs, which would also include the conversion. In addition, states can make their own laws to provide (or not) bankruptcy protection for Roth IRAs. So become familiar with the state law regarding bankruptcy in each state you are licensed in.

Estate tax planning should also be considered when making the decision to convert. If the client has no estate tax issues, paying taxes now to reduce the estate size does not make much sense. Also, if clients plan to use funds during retirement, they will most likely not be concerned with leaving a tax-free income to their beneficiaries through a Roth IRA.

A Worthy Technique

Roth conversions can be an excellent strategy given the right circumstances for the right client. Given the uncertainty of assumptions regarding taxes, investment performance, withdrawal rates and time horizon to retirement, careful consideration must be given before deciding to convert. Although we see the benefit of converting to a Roth IRA for many of our clients, as with any tool, it is not a fit for all clients and should be evaluated on an individual basis.

Kevin J. Meehan, CFP, ChFC, CLU, CASL is president of Summit Wealth Advisors, LLC, Itasca, Ill. You can e-mail him at [email protected]. Todd Diven, CFP, CPA, is an associate of Summit Wealth Advisors and can be contacted at [email protected].


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