This Article actually won Andy the coveted “2010 Fi360 Article Competition”. Fi360 promotes Fiduciary Excellence among financial advisors, which we at MMS Inc. take very seriously. Fi360 owns and awards the AIF and AIFA professional designations, provides analytical and reporting technology and ongoing support for all types of fiduciaries and financial service providers, including advisors, wealth managers, plan sponsors, trustees, brokers, accountants, lawyers and more.
Andrew I must tell you that I really enjoyed your article. I think it’s really quite excellent and for me what I got out of it is the importance of a kind of third level of thinking. The initial thought is that it’s a no brainier to decide to convert a standard IRA to a Roth. But when you think about it more deeply and put it in context of individual financial circumstances and the what if changes in tax law and the rest, you often will come up to a different answer… So, it was an example for me and what I hope my fiduciaries are doing…
Former US Treasury Secretary
Roth Conversions – “The Gamble of a Lifetime”
A lot of investors approaching retirement view the stock market as too much of a gamble once they reach retirement age. They’ve been told so many times that the stock market is just too risky and fixed income investments or a guaranteed annuity is all they need. Even though I don’t agree with that advice, most investors make their decisions based on perception rather than reality. So, in discussing perception vs. reality, let’s put aside retirement investment strategies for another time and address what I believe to be the biggest current “gamble of a lifetime,” the 2010 Roth IRA conversion.
This conversion has turned into one of the largest new business campaigns for financial sales people that I’ve seen in all my years of advising clients. In a very simple nutshell while excluding most of the technical issues and the reversal provision, the law allows all traditional IRA owners to convert 100% of their IRA to a Roth IRA starting in the year 2010 without income limits and/or marriage status requirements. If converted in 2010
There’s an old saying that the only sure things in life are death and taxes. As most investors are in no hurry to die, why would they be in a hurry to pay all of their IRA taxes upfront? More importantly, why would a financial professional recommend this conversion based only on the basic assumptions that: tax rates will forever increase, Roth IRA tax laws will never change and it’s better for clients to have a converted Roth IRA than their current IRA?
I wonder if advisors who believe those assumptions to be true ever consider additional issues such as the effects of their client’s future deductions for charity, medical expenses such as long-term care, mortgage interest, property taxes, tax credits, or even the effects of the clients overall estate planning objectives? This conversion goes deeper than just the tax effects of today. It impacts later years when there are children and even grandchildren to consider.
Let’s analyze the basic assumptions to determine if the conversion could be the “gamble of a lifetime” for your clients.
- Will tax rates increase forever? Based on history, the highest U.S. marginal tax rate from 1913 to 2010 has changed 36 times ranging from 7% to 94%. That range supports the case that tax rates could be higher in the future, but also indicates that tax rates could be lower in the future as well.
- Will Roth IRA tax laws ever change? No one can answer this question with certainty, but if our Congressional appointees can change the tax rates 36 times in nearly 100 years, I wouldn’t put too much trust in them never changing the Roth IRA’s tax-free status.
- A converted Roth IRA is better than having an IRA. Let’s compare the benefits of an IRA to the Roth. An IRA allows your client to leverage their own government tax dollars in order to make money over their lifetime. For example: If your client has a $500,000 IRA and a marginal tax bracket of 25%, that means roughly $125,000 of the $500,000 is government-leveraged tax dollars. If we then assume it earns 10% on the $500,000 each year going forward, your client is actually leveraging $125,000 government tax dollars to make more money. For every dollar earned on the leveraged tax dollar, the client keeps 75% if their marginal tax rate is 25%. So the question becomes, “Would your client rather have the investing power of an IRA worth $500,000 or a Roth IRA worth $375,000?” I think clients and financial professionals alike will agree on that answer.
- The effects of your client’s future charitable, medical, long-term care, mortgage interest, property tax deductions, and/or any future tax credits. You may be wondering what these issues have to do with the Roth IRA conversion. When income is received from an IRA, it’s subject to taxation. However, when income is received from a Roth IRA it is not subject to taxation. Therefore, all future income from a Roth used by your clients to make charitable contributions, pay medical bills, long-term care expenses, mortgage interest, property tax, or even receive a tax credit does not receive the same marginal tax deduction as does income received from an IRA. Basically, future tax savings with an IRA is negated once the Roth IRA conversion takes place, because the client paid all their taxes upfront.
- Effects on your clients overall estate planning objectives. What are the primary objectives for your client’s estate plan? If they want to leave money to charity at death, the Roth IRA conversion would be a complete mistake. Your client would be better leaving the balance of their IRA to charity, resulting in no income tax, as charities have tax-exempt status. Do your clients want to leave money to grandchildren for education? If so, a grandchild beneficiary-stretch IRA could be more advantageous than a Roth, as the stretch IRA allows longer tax-deferred growth. Also, required distributions are based on the grandchild’s life expectancy and tax paid at their immediate tax rate, which is usually a lot lower bracket.
- The US tax system is a progressive system and not a flat tax or regressive system.
- Realize that a Roth conversion will relinquish control of the client’s money to the government once they write that tax check. Clients can then only hope that the government will never want more.
- What’s the reason the government is allowing this unlimited conversion opportunity in the first place? Perhaps they need more money because of the astronomical U.S. debt. If that’s the case, remind your clients that at any time, they can send the government an extra check without converting anything!
While I believe these are valid arguments against the conversion, the major reason to have an IRA versus a Roth IRA is a client’s future need for medical expenses, long-term care or assisted living coverage. The following personal example further illustrates this point.
A client of mine is now elderly and was forced to move into a long-term care (LTC) facility. Therefore, I had to ramp up his income withdrawals to pay for his LTC costs as well as his other needs. I recommended we make all of his income withdrawals from his IRA. Previously, his income came from both IRA and non-qualified assets in order to better manage his total tax situation.
My reason for changing all his income withdrawals to his IRA was due to the known future medical expenses he would have at the LTC facility. I was able to arrange for him to use tax-deferred money instead of after-tax money to pay for those expenses. The actual medical deductions resulted in him paying roughly just 2% in taxes on all of his income.
The advantages that he and his family continue to realize from having his income source be an IRA instead of a Roth are immeasurable. The client got the benefit of contributing to the IRA at a 25% tax rate and now he’s paying an effective 2% tax rate. That’s a 23% tax savings for the client instead of the government, not counting its earnings over the last 25 years.
The same example can also be viewed as the partial funding from government tax dollars of the client’s LTC expenses. If you look at the same example, my client got the benefit of paying only 2% in taxes, meaning the government paid roughly 23% toward his LTC bills. When explained to clients and their families, that analysis is very comforting, as most of investment clients would never be eligible for Medicaid coverage once entering long-term care. Under this scenario, the client is still better off with an IRA instead of a Roth IRA.
I believe the reason many financial professionals are recommending this conversion is sales driven, rather than identifying what’s in the client’s best long-term interests. As a fiduciary, I cannot recommend that my clients take this gamble, as there are just too many unknown variables. In my view, there are only a few cases where this gamble may be worth it. For the vast majority of clients, it’s not.
Andrew D. Rice AIF, CTS, WMS, is vice president of Money Management Services, Inc., an independent registered investment advisory firm located in Birmingham, Ala., founded in 1992, with extensive experience in managing and advising high-net worth clients. He is an Accredited Investment Fiduciary, certified tax specialist and wealth management specialist. Reach him at 205-871-7526 or via email at firstname.lastname@example.org