Eight Questions to Ask About Roth Conversions

When further analyzing the application of the future tax rate, it's inaccurate to assume the highest tax rate for the options above, as it slants the opinion toward converting. As we know, qualified dividends and long-term capital gains are currently taxed at a maximum of 15%. In addition, consider that if those outside assets are invested in tax-exempt bonds, there may be no taxation at all (excluding capital gains and alternative minimum tax). Therefore, many of the most comprehensive conversion calculators inaccurately assume higher taxes on outside assets, which in turn, decreases the future projected value of those assets when presented as a comparison.

Apples to Apples

It's also critical to compare apples to apples in any analysis. I believe it's inappropriate for supporters of the conversion to recommend that a client take outside investable assets and use those to pay the tax bill, just to get the benefit of future tax-free growth on a separate pot of money. They further validate this assessment by presenting a simplified conversion calculation of the growth between a $500,000 IRA and a $500,000 converted Roth. In order to factually apply what most conversion experts are recommending, you have to compare the $500,000 IRA to a converted $375,000 Roth, net of the assumed 25% tax rate, and then answer the following questions to thoroughly project whether the future tax-free growth is really worth the conversion:

• How long will it take for the tax-free Roth to make up the difference of forfeited taxes, paid up front, when assessing the "lost opportunity cost" of future tax-leveraged earnings, which would have been generated from all the tax dollars if left in the converted IRA?
• Moreover, has the "lost opportunity cost" associated with having the proposed outside assets as after-tax investments been considered? The client had to pay taxes on that money at some point in the past, and now some are recommending clients exchange those assets as tax deposits just so they can have tax-deferred assets become tax-free assets.
• Granted, required minimum distributions are made from an IRA and not a Roth, but to be fair to the equation, did you reinvest the net after-tax income from the IRA distribution in an after-tax account to balance the equation, when assuming no distributions from the Roth during this same timeframe?
• Have you included a client's income needs from an IRA without also applying the same income needs against the Roth?
• Are you able to accurately predict each client's individual, spousal, child and grandchild's specific tax and income situations, year-by-year, over the next 50 to 100 years?
• Do you have factual information on what our country's tax laws will look like year by year over the next 50 to 100 years?

  Lastly, many colleagues are recommending a partial conversion option to balance a client's complete financial position between after-tax assets and taxable assets. While I definitely see a more reasonably calculated gamble with a partial conversion versus the full conversion, I still have a few concerns about this approach. Based on current IRA laws, a client turning age 70-1/2 has to start required minimum distributions (RMD) from their IRA account. When looking at required minimum distributions from a slightly different perspective, one could argue that the client is already being forced to make small partial conversions each year after age 70-1/2, just in a different form.

While you can't convert RMDs to a Roth, you can reinvest the net after-tax distribution into an after-tax account, assuming the client doesn't need the income. I realize this isn't exactly the same as a Roth's future tax-free growth; however, you don't have to deal with the five-year Roth holding rule after conversion. The after-tax account would pay taxes based on dividends and capital gains, which are only 15% if properly tax-managed, whereas with a Roth, you wouldn't. However, on the flipside, an after-tax account would allow a tax-deduction for realized capital losses, whereas a Roth doesn't. Also, an after-tax account could take a stepped-up basis to the fair market value at the date of death, depending on the total inherited assets at the time of death, which could involve some form of tax-free gain similar to a converted Roth.

So, when considering the assessment that a partial Roth conversion could be somewhat similar to an RMD, does your client really need to partially convert at all?

Obviously, the conversion issue is a very comprehensive situation with many unknown variables involved both now and in the future. Lacking a crystal ball, my question is, "What's the big rush, since the law now allows Roth conversions in any year going forward?" Having an IRA still allows your client to make a conversion decision at any time, but a 100%- converted Roth completely cements the client's position (once past the allotted reversal period), leaving them with few other options. In my view, the conversion still remains "the gamble of a lifetime."

Andrew D. Rice AIF^(R), CTS(TM), WMS, is vice president of Money Management Services, Inc., an independent RIA firm in Birmingham, Alabama. He is an Accredited Investment Fiduciary, Certified Tax Specialist and Wealth Management Specialist. E-mail him at [email protected].