Where we were, and where we are
For background, it is important to understand that until 2010, if an individual or couple wanted to convert all or a portion of their traditional IRA balance(s) to a Roth IRA (basically a choice between current taxation and future taxation), they had to have a Modified Adjusted Gross Income (MAGI) of under $100,000. As part of the Tax Increase Prevention and Reconciliation Act of 2006, congress made a modification to this rule eliminating the income ceiling for conversions after 2009. This means that anyone who wants to can convert to a Roth IRA, no matter their income, age or size of the account being converted. Basically, if you want to convert in 2010, and are willing to pay the taxes now, you can. Additionally, for conversions made in 2010, you have more than one option for paying the resulting tax liability. You can pay it all in 2010 (by the tax filing deadline) or defer and pay ½ in 2011 and ½ in 2012.
Why is congress making this change?
It would be nice to think that the members of congress have decided out of the goodness of their collective hearts to help us average working folks out a bit. However, as with most things in life that seem too good to be true, there is a catch. As previously noted, if you convert from a traditional IRA to a Roth IRA, you are required report 100% of the conversion amount as current ordinary income. In other words, the government gets their much needed tax revenue now as opposed to waiting until you turn 59 ½ (or older) and begin drawing down your IRA account. Clearly Uncle Sam is a firm believer in the old adage “A bird in the hand is worth two in the bush” (note that we refrained from inserting a George Bush joke here). What we are left to ponder (knowing full well that congress is unlikely to leave huge tax receipts on the table despite their eagerness to get their hands on this money quickly) is: Is this really a good deal for us? The answer to this question is a resounding ‘Maybe’. To clarify, we need to take a look at the arguments for conversion.
Why would I convert?
Of course the big question is, why convert? Why pay taxes now for the right not to pay taxes later? If you do some research you will see there is no shortage of possible answers. The two most common reasons being thrown about are, first, that tax rates will likely be much higher in the future than they are now, and second, that you may not need to spend these funds in your lifetime so converting to a Roth IRA now could well save your heirs a substantial amount in taxes down the line. While these are both valid points, we would argue that, regarding first point, predicting future tax rates is a tricky business and it is not at all a foregone conclusion that rates will be substantially higher in the future. As to the second point, while some who are still a ways off from retirement are already
primarily concerned with effective generational asset transfer, most people we talk to consider asset transfer a secondary concern after knowing they have carefully planned and saved for their own retirement.
While we may take issue with some of the more trendy reasoning for conversion as outlined above, we believe there may be a more compelling argument for converting at least a portion of your traditional IRAs to Roth IRAs, which boils down to one thing; Flexibility.
Our recommendation
For those of you who have worked with us for any length of time, you are familiar with our mantra about the importance of diversification. We firmly believe diversification and flexibility are the cornerstones to a healthy financial profile. Essentially, what the Roth conversion allows for is flexibility or ‘tax diversification’ as a hedge against future legislative maneuvers and tax law changes.
If you could tell us today what the tax code will look like and what tax rates will be when you start taking money from your IRAs in 5, 10, 20, or even 30+ years, this conversion question would be as easy to answer as so many have made it out to be. The truth is, particularly in today’s political climate, it is impossible to determine what legislative changes will be made and what tax rates will be in effect in 3 months, let alone many years down the line. That is why flexibility is so vital.
It is always our recommendation to have a good mix of non-qualified and qualified assets available at retirement so clients have more options available for their portfolio withdrawals. By having some money available at capital gains rates (non-qualified), some available at ordinary income tax rates (qualified), and some available tax-free (Roth IRAs1, etc.), clients are better able to manage their total tax obligation regardless of the tax-structure in effect at the time of their distributions. It may be necessary to give up a few dollars along the way to hedge your bets (in the form of taxes upon conversion), so that regardless of what the political or tax-rate structure is in the future, you will be able to take advantage. Basically, this is another strategy for the unknown and unforeseeable future, something we think everyone should consider.
As nice as it would be, there is no one-size-fits-all solution to the issue of Roth IRA conversions. The correct answer depends on many factors and should be carefully considered from all angles prior to any action. Remember, if you want the option of deferring taxes on a 2010 Roth IRA conversion until 2011 and 2012, you will need to talk to your financial professional(s) and act soon.
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1The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions apply. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
