Clearing The Air On Roth IRA Myths

With the following two questions, you can immediately determine if an individual should convert their traditional IRA to a Roth IRA. This requires no long involved spreadsheet or reams of computer output, only two questions. The answers to these questions are simply: yes, or no.

The two questions that I ask are:

1. Are you over age 59?

2. Do you have funds outside the IRA with which to pay the income tax, if you were to convert to a Roth?

Now the answer guide is the part that people find astonishing. If either answer is yes, they would be better off converting. Thats right, if they answer either question yes, they should consider the Roth conversion.

So, the corollary to the two-question quiz is that

1. Everyone over 59 should convert.

2. Everyone under 59 should convert, if they have outside funds to pay the tax on the conversion.

Those two assumptions mean the group that should seriously consider converting is very large.

Now, lets take a look at the math. Suppose that you had $300,000 in a traditional IRA. Also, you have $99,000 in a money market account outside of your IRA. Lets calculate the value of the assets using what appraisers would call the income method. To make the calculations simple, the assumptions for this example are that everything grows by exactly 10% every year. Further, assume that taxes are paid at a 33% rate.

Now lets calculate the value of this $399,000 portfolio using the income approach. Although you do not need income from these assets we can best determine their value by measuring the income that they could provide, on an after-tax basis.

So, from the $300,000 IRA at 10%, the annual income would be $30,000.

Now how much income tax would be due on that if we took the income?

$10,000

So our net income from the IRA would be $20,000. Now we invest the $99,000 at 10% and it produces $9,900. After paying 1/3 tax, the net income would be $6,600. So the total annual income would be $26,600 from this portfolio.

Lets compare that to the Roth conversion. For you to pay the entire tax ransom on your $300,000 IRA and make it a tax-free Roth, you must pay the tax on the IRA today. This means that the entire $99,000 in money market is going to the IRS today.

How does this make your client feel, to give the IRS this $99,000? Sick? Well, lets run the rest of the numbers anyway. You now have $300,000 in a Roth IRA. The gross income would be $30,000. The tax would be$0; thats right, Roth IRAs are income tax-free.

So your net income from the Roth is $30,000. What was your income from the regular IRA and the money market account?

$26,600

Which is more? Put another way, who is richer, a woman with a $300,000 regular IRA and $99,000 in a money market account or a woman with a $300,000 Roth IRA?

And this is just the beginning, for if the prospect is not likely to spend any income from the IRA, the amount of the Roth advantage gets greater every year.

I have seen so many articles concerning Roth IRAs in both the general and financial press that have been filled with errors, inaccuracies, incorrect innuendo, and just downright bad advice.

I have also received many phone calls from people who discussed Roth IRAs with their stockbroker, butcher, banker, accountant, neighbor, the clerk at their brokerage house or some other Roth "expert" who had given them some misinformation. I would like to take this opportunity to clear the air on the most prevalent misconceptions about Roth IRAs.

Myth number 1

"You cannot use the money converted to a Roth IRA for five years without additional taxes and penalties."

Wrong.

You may use up to 100% of the amount transferred or contributed to a Roth even the day after you convert without any additional taxes (and no penalties if you are over 59). Roth IRAs use FIFO accounting, which means that any withdrawals from a Roth are first considered from the principal or basis, which is tax-free. After 100% of the amount of your transfers or contributions have been withdrawn, then taxes or penalties may apply, but then only if the five-year rule has not been met.

Myth Number 2

"It takes years for the Roth conversion to catch up and exceed my regular IRA or IRA rollover."

Wrong.

Many people who convert from a regular IRA to a Roth IRA have more spendable (after-tax) money from the very first day they convert. If the conversion temporarily pushes you into a higher tax bracket, you may have less spendable money for a time (typically a very short time). This amount of excess spendable money created by the Roth conversion then usually grows even greater over time.

Myth Number 3

"Roth conversions are for the young."

Wrong.

Due to the mandatory distribution rules of regular IRAs and retirement plans, the Roth may have an even greater advantage for those age 70 and over who convert to a Roth.

Myth Number 4

"My income tax rate will be lower when I retire."

Maybe not.

Most of the clients that I have had through the years thought that this would be the case. However, for almost all of them, the older they get, even through retirement, the higher their income tax bracket.

Myth Number 5

"My regular IRA is my money and it is worth what the brokerage statement says that its worth."

Wrong.

The IRA or rollover account is always worth less than the account statement says that it is. This is because you have a partner in the IRA on every pennycalled the IRS.

Myth Number 6

"My spouse and I can pass to our children $2,000,000 without any estate tax."

Not always.

If an IRA is a substantial part of your assets, it is often needed to fund the bypass trust created at the first death. In a very high percentage of cases, the IRA cannot be placed into this bypass trust. If the non-IRA holder spouse dies first, the IRA may not even be considered as an asset of the bypass trust. Even if the IRA is available for this bypass trust, it is often not utilized due to the adverse income tax consequences of holding the IRA in trust.

What this means is that many people who are married, with their IRAs representing their main asset, will only have the one estate tax exclusion of $1,000,000.

Myth Number 7

"My income is too high to qualify for the IRA conversion."

Maybe not.

It is true that your modified adjusted gross income has to be $100,000 or less in the one year that you convert to a Roth IRA. However, many of my clients with substantially higher incomes have met this qualification with careful income tax planning. Remember this $100,000 limitation only applies to the conversion year.

Myth Number 8

"The Roth conversion will not be advantageous to most people, and for the few people that it would help, it really only benefits their heirs."

Wrong.

As mentioned earlier, there are two main categories of people who can benefit from the Roth conversion. The first type is anyone over age 59. The second type is anyone else who has funds outside their IRA with which to pay the taxes upon conversion. These two categories comprise a large number of the folks who have regular IRAs. Additionally, the benefit is to the person who converts, as they are able to enjoy more in after-tax spendable income for the rest of their lives. To the extent that there is money left over at death, then the Roth conversion further benefits their heirs.

Myth Number 9

"The IRA can be deferred for a long time after I turn age 70, and when I die my spouse or heirs will be able to continue this deferral for a long time in the future."

Not likely.

Most IRA holders desire this so-called "stretch out," or maximum deferral strategy for their IRAs. However, the mandatory taxable withdrawals are in reality much faster than desired. This is often due to the first death occurring later than anticipated as well as the "wrong spouse" (non-IRA holder) often dying first. Keep in mind that Roth IRAs have no mandatory lifetime withdrawals as well as no elections (irrevocable or otherwise) that must be made at 70. As a result, if maximum income tax deferral is your desire, then the Roth is a much better vehicle.

Myth Number 10

"My congresswoman or favorite presidential candidate has assured me that a flat tax is near, and this flat tax rate will be so low that the Roth conversion will have no significant advantage."

Dont tell me that you fell for that one!

The majority of political pundits do not believe that a flat tax is in our future. Even if we were to have a flat tax, the flat tax rate would have to be so unrealistically low (17% or so) for the Roth conversion to have been a mistake.

So many people who have large IRAs have never even seriously considered converting to a Roth. This is because the immediate payment of the income tax is unpalatable to most. However, if you were able to explain the immediate and long-term advantages the Roth might have for them, most would be astonished.

The largest insurance policies that I have sold in the past few years were incidental to whether or not the client actually converted to a Roth IRA. The clients with large IRAs are keenly interested in the most efficient ways to deal with the taxes on their IRAs. And, since I showed them many of their possibilities including Roth IRA conversions, they allowed me to do other work often including large life insurance policies inside of trusts, which is my core business. As Zig Ziglar likes to say, "You can get anything in the world that you want, as long as you help enough other people get what they want."

, CLU, CFP, of Associates, Highland Village, Texas, is an estate and retirement specialist. He can be reached via e-mail at john@

johnbledsoe.com. This is an abridged version of a presentation he gave at the MDRT meeting in Nashville.

Reproduced from National Underwriter Life & Health/Financial Services Edition, July 1, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

Clearing The Air On Roth IRA Myths

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Clearing The Air On Roth IRA Myths

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