Discussion:Advising clients on Roth IRA conversions

I am getting more and more questions from people about converting their Traditional IRA or Rollover IRA to a Roth IRA. I have done quite a bit of research on it and I think I understand the functional issues at hand. My questions are more conceptual in nature.

First, most of my clients are bumping the 2009 $100,000 income limits so I am advising most to wait until next year to even consider it for two reasons. First, in 2010 the income limits will disappear. Second, the taxpayer will be able to spread the tax due over tax years 2010 and 2011.

However like many of the taxpayers today, many of my clients have some decent balances in their IRA/Rollover IRA's which will lead to some significant tax bills for the conversion to Roth IRA's. For those that cannot come up with the cash to pay the taxes, they are able to take a portion of the IRA (during the transfer) to pay the taxes but will be subject to early distribution penalties on the amount withdrawn to pay taxes if they are younger than 59 1/2. I haven't found any exemptions for the early withdrawal penalty--even though the IRS is pushing this to increase current tax revenue to the Treasury. Since there is no exemption to the penalties, this may make the decision to rollover to a Roth IRA a little more cloudy.

The side issue is that I have a few clients who have the ability to contribute to a Roth 401-K at work. Whether the client can effectively do the Rollover to a Roth IRA, it might make sense to change contributions from a 401-K to a Roth 401-K.

The most important issue to these discussions is whether the future Congresses will raid the retirement accounts....and we have no way to forecast that 20 years into the future. Given the spending of the current and past administrations and the fact that government spending cannot decrease (there is no mechanism for reducing spending, just reducing the GROWTH of spending). There have been several ideas floated by the democratic leadership about overhauling tax deferred retirement tax law (401-K and IRA's) to remove tax preference on these types of accounts. Ideas I have heard were a one-time ~15% tax on balances in retirement accounts to pay for retirement accounts for poor people and forcing people to remit their retirement balances to the government to be put in an account similar to social security. In any event, it is clear that the party in control of DC right now has its sights set on retirement accounts. My experience with government is that once powerful people set their sights on something they want to do, they will get it...whether incrementally or in one big push.

what are you advising your clients to do at this point?

It would be a shame to advise someone to take the tax hit now (while their income brackets are lowest of their lives) only to incur a later assessment or complete removal of the benefits we are advocating to the client of converting to the Roth IRA.

Thoughts?

Thanks,

BrockEA

Remember, if you make the rules, you can also make the rules that break the rules.

It reminds me of the old Wimpy character's "I will gladly pay you Tuesday for a hamburger today". I just simply worry that a 20 something will see the Roth IRA complete.

BrockEA

It doesn't matter what the Republicans and Democrats do anyway. For the forseeable future, our tax policy will be made in Peking. The Chinese expect to collect on their investment in our Treasuries.

The tax is spread of '11 and '12....thanks for the correction D&T.

(also worth noting that the spread between '11 and '12 occurs after the Bush tax rate changes expire...concidence?)

This seems to be the wave of the future and the idea is being touted very heavily by the government. I know a lot of people who are taking the word of advisors at Fidelity, Etc. and just doing it without proper tax advice.

BrockEA

However, the Bush admin outspent every administration before his...possibly combined. I believe that if the current administration hasn't already outspent Bush's, it will soon. If this healthcare plan is passed, I think that will be the proverbial straw that breaks the camel's back. In any event, there is no mechanism in place to reduce spending, only increase it so all administrations past, present, and future will have a hand in it---regardless of party.

But I do not want to ignite a political war just point out that the current spending level levied in the past and most definitely by this current administration will necessitate tax revenue. Such a crisis may be the catalyst needed to move on the retirement accounts in some fashion or other.

However, I don't want to let my pessimism regarding our government spending affect my ability to properly advise a client. Having said that, I have to make a call either way and both involve some level of ambiguity. Given the mess we are in now with our economy, the insatiable spending that will occur going forward, and the multiple government entities that stated their intentions with regards to the deferred retirement accounts, I will have to lay odds that 20 or 30 somethings will not see the benefits of the Roth they expect.

BrockEA

Sorry! I saw this soapbox just sitting here unoccupied. I will step down now.

BrockEA

If we don't argue about this, what will be left? :D

There is plenty of blame to go around.....but IMHO given the fact that the government is essentially in default already (due to ALL administrations before combined), spending 1+ TRILLION dollars on healthcare isn't wise. Regardless of which party is in office, I fear that the leaking ship has already sailed.

However, for the purposes of this conversation, it is the DEMOCRATIC party wholly and without exception that has been targeting retirement accounts. It was DEMOCRATIC conference in which the DEMOCRATIC party had a speaker who suggested that after the election, the DEMOCRATIC congress should force people to remit their entire retirement accounts to the government and allow it to be managed by the same government that took your Social Security funds and put in IOU's (that part was both parties). It was Clinton's people that floated the one time assessment of your 401-K during his term but apparently determined it wasn't the time. So for the sake of my questions regarding Roth IRA's, it is uniquely the democrats who are floating ideas at getting their hands on your retirement accounts.

Unfortunately, it is impossible to separate tax policy and politics.

BrockEA

Income Tax law is no place for social welfare and/or economic stimulus programs.

"Make Income, Pay Tax" is OK with me, but "Buy House, Get Reward" isn't appropriate in the income tax arena. I had written it out so much better before, but I was so flailingly mad that I erased the post before it became a post.

More PBR will help.

I do agree with Wiles. We need to stop the entitlements. How we ever convince the rich that they are not entitled to bailouts and special favors, I don't know, but we need to work on it. They've been on welfare since Reagan got in there, and we need to wean them off of it.

If only, instead, we had formed a republic with some sort of legal document that established laws and restricted government powers when we started this whole mess called the U.S.

Let me ask it this way, are there any practitioners here who think the conversion to the Roth IRA is a GOOD idea?

I simply don't....the formulas tell me that I will be much better off by personally doing it but those formulas assume a consistent code. I would have to lay odds, if I were a betting man, that the Roth IRA of today will not be here in 20-30 years.

BrockEA

BrockEA

For 2007 Top 1% of taxpayers (AGI's in excess of $410,096) paid 40.42% of all personal income taxes

Top 5% of taxpayers (AGI's in excess of $160,041) paid 60.63% of all personal income taxes

Top 10% of taxpayers (AGI's in excess of $113,018) paid 71.22% of all personal income taxes

Top 25% of taxpayers (AGI's in excess of $66,532) paid 86.59% of all personal income taxes

Top 50% of taxpayers (AGI's in excess of $32,879) paid 97.11% of all personal income taxes

See, this is exactly what Crow is talking about. Why should the bottom 50% of taxpayers be forced to pony up a full 2.89% of all personal income taxes? It's just not fair!

And how many on each side of the aisle voted to end the party by rejecting the extension of the FTHBC......my God, they fell over themselves giving more people benefits, including permitting couples with incomes up to 250K the ability to jump on board, and keep their current house, if they can find a lending institutuion to give them a mortgage.

Sorry Jdugan, but I do question your conclusion. It's WHAT you pay taxes on that counts. The rich can finagle what they pay taxes on. Old man Buffet himself has discussed this.

A tax cut is an expenditure simply because it cannot be permanent. It's a gimmick. Another government program. If you think they can be permanent, you are not reading the newspapers (well, I guess no one reads newspapers). The rich have gotten their fair share of tax cuts and loopholes since Reagan revolted. (And he was revolting).

We put the rich on welfare back under Reagan with the idea that all that wealth would trickle down. Now, we are well on the way to wiping out the middle class, and it's all going to the top 10%. I don't envision that kind of America as a place I want to live in very much.

It's only going to get worse after this financial disater which was caused by the reckless rich, and which they have so far managed to escape responsibility for. These bonsues are a perfect example. I've yet to figure out why we need to retain any of these people. Do they not realize that their high class gambling has put the county in bankruptcy?

What I get tired of is the constant lie that the poor are all on welfare. That's as bad as me saying that the rich are all on welfare. You get 5 years of welfare. Up or out. Now, if we could just extend that concept to the rich, we'd be ok.

I say fawning over the rich is better than following the poor. I figure, who better to model my life after, some successful fat guy with grey hair or some bum pushing a shopping cart in some suburban area. :D I guess I would say that I am in the middle on these topics because just as much as the 'rich' were given breaks, the poor has had untold money poured down the welfare hole and that has been a colossal failure.

I gotta disagree with you partially on what caused this financial mess. Sure the powers that be in the banking industry are owed their share of the blame, maybe a lion's share. However, if memory serves me it was slobering barnie frank, his boyfriend at the freddie/fannie, Clinton and his leaders who relaxed the lending standards which led to people who couldn't afford mortgages being given them. I don't hate on the poor, just dislike the character of those that remain poor for very long.

However, there is plenty of blame to be passed around. I guess that it could be encapsulated very well in the fact that if the Federal Government of the United States abided by the powers given it in the Constitution, we wouldn't be in this mess. Some blame the rich, some blame the poor...I blame the government (except for the OPR and the Treasury Secretary who are considering my Form 23 as we speak). :D

I guess that the comforting part is that like the weather in Kansas where, if you wait long enough will change, the US will eventually spend itself out of existence as we know it. I was born in 1970 and if you look at the Federal budget then compared to now...it will not take the US government another 38 years to double that amount again. We simply cannot sustain that type of spending and have no mechanisms to cut spending. So the day that the Chinese decide it no longer wants us around, it stops buying our debt (perhaps in a world-wide coordinated debt avoidance 'attack') and we close shop and go out of business.

BrockEA

Or, they may raid the retirement plans to spread the wealth?

Perhaps ask the client about their forecast of the economic future. If they are optimistic go Roth. If they are pessimistic take the deduction now in a regular IRA or other retirement plan. Pay taxes in the future when one's income is minimal.

Advise clients about the law and factors to consider. Have clients tell you what they want to do. Many will still ask you what you would do: you can mention that your view of risk compared to your client makes your opinion insignificant.

What we have seen in the past twenty years is the Socialization of both credit and risk......at least until September 15, 2008 when those in power at the time and partially responsible for inflating the balloon decided to throw in their chips. In great part this was a reaction to the monies pumped into the economy by the Fed in the early 90's to solve the Saving and Loan crisis [anyone remember the Reconstruction Finance Agency?].

Credit was given to anyone, many of whom were not qualified, but behind the curtain was the Fed and Treasury, ready to rise to the rescue and save the lenders. It was our form of The Great Game, and was approved by all but the most hidebound of fiscal conservatives (of either party).

read some James Grant: http://www.washingtonpost.com/wp-dyn/content/article/2008/10/03/AR2008100303309.html

One thing David: why did we have to socialize the credit? Why did Americans need all this credit? Partly, because they couldn't make do with their incomes. Per capita income has been worse than stagnant since the 1970's. You can't use household income becuase it's a false statistic (one man could support a household before Reagan, it took a Village after Reagan).

All these people that have bashed the unions for years didn't bother to consider that a union employee could support a family with dignity AND bring business to the local dry cleaner, florist and candlestick maker.

Like Henry Ford said: I pay my workers well so they can buy my cars. (The old rascal knew what he was doing).

All this may change with new legislation, but given the states economic hardships, I can see them tapping the easy cash available here.

You know that most of our clients will want to defer making the payment as long as possible....human nature, something might come up.....they might die and never have to grimace while writing the check.

Anyway, I don't fawn over the rich. But I tend to get a job (or more business) from those weathier than me and I tend to hire people to work for me who are not as weathy as I am (must be why I don't hire many people to do things.) But I know for certain that if we line up all of the people in the top 10% and shoot them and redistribute their wealth from the bottom up so, it won't be long before the wealth will again be unevenly distributed.

Back onto the topic of Roth IRA's. It seems to me that most people don't really understand the mechanics of a Roth. Financial advisors always say invest in a Roth, because it will provide a bigger retirement. Well, that might be true, but the reason it might be true is not thought out. If you were to take the caps off of the annual contribution to an IRA and look at it from an "apples to apples" perspective, given the same tax rate in the year the IRA is made as when it is withdrawn, then comparing the same "net investment" of a regular IRA and a Roth IRA will provide the exact same end result. Here is what I mean.

Compare a $3,000 ROTH contribution to a $4,000 regular IRA, 25% tax rate at both the front and the back ends. The "net investment" in either case is the same, $3,000. Left in there long enough, each will double (or maybe halve, but that's another story). So the Roth ends up with $6,000 tax free, the regular IRA ends up with $8,000, but is subject to a 25% tax. Voila! $6,000 after tax for both.

Since the caps allowed for regular IRA's and ROTH's are the same, contributing the max to a ROTH will provide a greater end result, because contributing to a ROTH means you are investing the full amount and not getting a refund from the gov't reducing the amount of your "net investment".

But, in my experience, since I don't deal with the super-rich, most people's income drops when they quit drawing a salary. With the drop in income usually comes a drop in tax brackets. So most mid-to late career people who have a significant dollars in a regular IRA or retirement account will not benefit by converting to a Roth and paying the tax now. Because if they pay the tax today, they are at the top of their earnings potential, thus their top tax bracket of their lives. So a 25% taxpayer will likely drop down to 15% bracket at retirement. A 28% taxpayer will drop to 25% or even to 15%, depending upon how well they have saved for retirement.

There are lots of other reasons for considering a ROTH account. But in evaluating whether it is worthwhile to convert, you must consider that any tax paid on conversion is in effect another investment.

I saw that 'heresy' in Spidell's Elder Care Newsletter a couple of years ago and bring it out every so often. You hit one real good point: how many times do I hear those who really don't need a Roth want one because some low rent investment advisor [I won't name names] says they are great.

I usually like Roths where the people will never need the money and want to pass it on to their heirs.

I think you are agreeing with me while saying others call this line of thinking heresy, but I am not quit sure.

Yes, there are other valid reasons for doing a ROTH rather than a regular IRA. One main reason is if your retirement savings are limited to only doing the current year IRA limits, (that is, you have no ER sponsored retirement plan, then the ROTH permits a larger "net investment".

A second valid reason is that it can "trick" the client into saving more. (They don't really get that the tax deduction they are not getting currently is in fact an additional investment.)

A third valid reason is if you participate in a retirement plan and are still eligible to contribute to a ROTH. The ROTH IRA beats the non-deductible IRA hands down.

Your reasoning of being able to pass it on to heirs is another. All of these issues should be considered.

I find clients in your third situation are very aware of the benefits; in fact at least twice a tax season I have to instruct clients to recharacterize the Roth contribution because income is too high. Several times I have found new clients have been contributing to their Roth for several years, even after their income surpassed the limits.

But in the other cases, I could talk forever, and show them all sorts of projections etc., and they will choose the tax deduction now almost every time. If they do choose a Roth, it is usually because their Ameriprise sales person has talked them into it!

http://www.taxalmanac.com/index.php/Discussion:Roth_Surprise%21

15% really is 29% (new math, you know).