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.