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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Sunday, March 21, 2010

Roth Conversions – No Slam Dunk!

Numerous articles in the newspapers, financial magazines and on the Web are touting the great opportunity we have this year to convert our IRAs and other retirement accounts (401(k)s,
403(b)s, etc.) to Roth IRAs. While there are significant benefits to Roth IRAs, the issues involved are more complex than first meets the eye. Conversions are not for everyone and perhaps for fewer people than most originally thought.

The Roth IRA is a wonderful concept. While no tax deduction is allowed for contributions as with a regular IRA, the account grows tax free and qualified distributions are tax-free. What’s more, there are no minimum required distributions for Roth IRAs as there are for regular IRAs,
401(k)s, etc., when one reaches the age of 70 and ½.

Prior to 2010, individuals with modified adjusted gross incomes (MAGI) greater than $100,000 could not convert to a Roth IRA. Starting this year, that restriction is eliminated. What’s more, the tax on the income from converting to a Roth can be either paid in 2010 or spread equally over 2011 and 2012. Sounds like a great deal? It may be and then again it may not. It all depends on your particular situation.

Delaying the conversion taxes until 2011 and 2012 sounds like a good deal until one considers that Congress may likely allow the Bush tax cuts to expire at the end of this year. Therefore, it may or may not be better to pay the taxes over 2011 and 2012.

Two key considerations for determining if it’s wise to convert are:

(1) Will your tax rate in the future at the time you take distributions from the Roth be greater than the tax rate on the conversion income? If not, the benefits of converting may not be that great.
(2) Can you pay the conversion tax from non-retirement accounts and without triggering substantial capital gains.

If the above conditions can’t be met, the benefits of conversion may be minimal at best. With our current economic crisis and mounting national debt, it seems like a given that taxes will increase for everyone going forward. Yet that may not be the case for all taxpayers.

Benefits also depend on how long it will be before distributions are taken from the Roth. The longer one can wait before taking distributions after conversion, the better the benefits. Conversely, if you will need to withdraw a significant amount of the Roth to live on soon after converting, it likely will make little sense for you to convert.

A key assumption in converting to a Roth IRA is that they will forever grow tax free and yield tax-free distributions. This may be a false assumption, according to Edward F. McQuarrie, Ph.D, a professor at Santa Clara University’s Leavey School of Business. In an article in the December 2009 Journal of Financial Planning by Richard Stolz titled “Bonanza or Bust?, Roth Conversions in 2010”, Mr. Stolz quotes Mr. McQuarrie as follows:

“The idea that Congress will never change today’s Roth provisions for the worse, for the
rest of your life and the life of your heirs, requires more faith than reason, and a
naiveté that would be touching if it wasn’t so dangerous to your financial well being.”

Mr. Stolz went on to say in his article that McQuarrie has outlined a number of ways Congress could affect the tax-free status of Roth IRAs. One in particular, is what McQuarrie called “excess Roth accumulations”. McQuarrie was quoted as saying in a March 5, 2005 article titled “Breaking Faith in Savings is Very Easy”, that “Congress could look voters in the eye and say we’re not taxing your Roth – all you have to do is take a big enough tax-free distribution each year to keep your account balance below the excise tax threshold."

There are a number of other issues to consider when making a decision about Roth conversions. It’s not as simple a decision as it may seem. We highly recommend you consult with a knowledgeable advisor before converting to a Roth IRA.


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