Mid-year Roth conversion gut check

By Chris Conklin

Insurance Insight Group


On January 1, 2010, a change to the tax code took place which, for the very first time, allowed people with a household taxable income exceeding $100,000 to convert their traditional IRAs to Roth IRAs.

This created a sales opportunity for financial advisors and a long-term tax-saving opportunity for clients. Because of the interest in this opportunity from both advisors and the general public, there have been many articles published on this topic, and most financial firms have made marketing materials available to their producers.

Consider these facts, all of which would seem to point to a potential flood of Roth IRA conversions about to take place:
    1. There is a lot of money in traditional IRAs: Per the Investment Company Institute, there is more money in IRAs than in employer-sponsored 401(k), 403(b), and 457 plans combined.1 Per the Employee Benefit Research Institute, 95 percent of IRA money is in traditional IRAs, not Roth IRAs.2

    2. Roth IRAs have much better tax treatment upon withdrawal: Withdrawals from a Roth IRA after age 59½ and after it has been in place at least five years are 100 percent free of income taxes. Withdrawals from a traditional IRA are taxable.

    3. People can pay the taxes: People with a household taxable income exceeding $100,000 are much more likely than people with lower incomes to have substantial savings available to pay the taxes due upon conversion.

    4. People believe tax rates are going up: Roth IRA conversion generally makes sense if you believe that you will be subject to higher income tax rates in the future than you are now, and the vast majority of people believe that federal and state governments are going to increase income tax rates, particularly on upper income individuals. The trend has already started: the scheduled federal income tax increases for 2011 are substantial.3
Has the flood of Roth IRA conversions started to take place?

The answer, per an article by Annie Gasparro of the Wall Street Journal, is that the volume is up, but it can hardly be characterized as a flood. Several brokerage firms saw conversions by their clients quadruple in the first quarter of 2010, but many clients who had expressed interest are deciding not to convert.4

Perhaps your clients have personally considered Roth IRA conversion to be an attractive proposition. Their thought pattern was likely this:
  • Do I own a traditional IRA, or do I have 401(k) money sitting with a former employer? If yes, then:

  • Do I believe that federal and state income tax rates are generally going to increase in the future? If yes, then:

  • If there was a way to pay taxes now on the existing balance of my IRA (at a lower tax rate) to avoid paying taxes on that balance later (at a higher tax rate), and if doing so also provides an opportunity to avoid income taxes altogether on the future growth of my IRA, would I be interested? If yes, then:

  • I should strongly consider doing a Roth IRA conversion.
And yet, despite the fact that nothing may have changed to alter the above thought pattern, perhaps your clients still haven't pulled the trigger on a Roth IRA conversion. That makes this article your mid-year Roth IRA conversion gut check.

What is holding you back?

If your clients are like most people, the reality of paying taxes now is tougher to take than they expected. Stephanie Ackler, a New York-based financial adviser at Wells Fargo, says that when she discusses the tax expenses with clients, they almost always abandon the idea of converting. "At the end of the day, a lot of folks aren't getting excited about writing a big tax check," she says.4

It could also be that they think that all of the money in their IRA is, in fact, theirs, and therefore they are not mentally prepared to write a check against it. Similarly, financial advisors commonly perform an analysis of how many years of growth will be required to restore the IRA and other retirement savings to their pre-conversion balance. The thought pattern and this analysis ignore the fact that since the traditional IRA balance is pre-tax money, a good portion of it is ultimately owed to the government, whether is it convert or not.

It could also be that your clients don't trust the government not to change the rules. Advisors Trusted Advisor conducted a survey of 242 investment advisors in April and May, asking why there was not a flood of conversions so far. The survey found that many investment advisors and clients believe the government will pull the rug out from under taxpayers who convert. They fear that the government will somehow change Roth account rules in a way that will turn converters into losers.5

So, is the reality of paying taxes now tougher than your clients expected? They may be kicking they thinking that their IRA balance is really theirs? The fact is that the government owns a portion, and if they increase tax rates, the portion they own increases retroactively to the first dollar. Are they thinking the government will change the rules? The easiest rule for them to change is to increase tax rates on money that is already taxable.

In conclusion, these statements are nothing more than my speculations. I am not a professional tax advisor, and your client absolutely should seek the advice of a qualified professional. I am not responsible or liable for their tax decisions - they are.

But if they previously expressed interest in a Roth IRA conversion and then decided not to do it, here is their mid-year gut check. Tax rates are scheduled to increase in 2011. The best time to pay just might be now.

*This article is for general information purposes only. Neither the author nor Insurance Insight Group provides tax advice. If such advice is needed, the advice of a qualified advisor should be sought. No party assumes liability for any loss or damage resulting from errors or omissions in the use of this material.

1"The U.S. Retirement Market, 2008", published by the Investment Company Institute, June 2009
2http://www.ebri.org/pdf/PR_801_13May08.pdf
3http://atr.org/six-months-untilbr-largest-tax-hikes-a5171#
4http://www.marketwatch.com/story/story/print?guid=76968c52-c302-4de1-88da-987359263ad6
5June 18, 2010, National Underwriter website, "Advisors: Many Skeptical about Roth Conversions"


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