Does A Roth IRA Conversion Make Sense For Your Clients?
by Thom Hunzicker MBA CFP

More clients have been asking about the benefits Roth IRA conversions – probably as a result of the increasing press coverage. Advisors need to become well acquainted with this subject, as the threat of increasing income tax rates becomes a major concern to those newly retired or those in retirement. This article discusses the very basics of Roth conversions for retirement accounts, such as 403(b) and 401(k) accounts and traditional IRAs.

You should understand that the income clients receive from a Roth account is not only tax free, but it is also lowers adjusted gross income. So, it saves the client income tax dollars in additional ways. Some say the Roth conversion is the greatest gift the IRS has ever given to the American taxpayer. We could debate whether the IRS could ever be that generous, but for the right situation this absolutely is a great tax break. Since this conversion is not for everyone, it must be well understood and analyzed very carefully before a taxpayer jumps into a conversion. Even though a conversion can be undone, too often folks find out too late to take corrective action.

Benjamin Franklin once said that nothing is certain in this life but death and taxes. So, it makes sense to stave off both. If you examine your clients’ tax returns, you may find that the limitation on deductions, due to the level of their adjusted gross income, has affected their taxable income.
Certain items can be reduced due to a greater adjusted gross income, such as deductible medical expenses (including, long-term-care insurance premiums) and charitable donations, plus casualty/theft losses, and other individual deductions. Also, if the client’s adjusted gross income is above a certain level ($156,400, married for 2008), there is an overall limit on total deductions. This automatically reduces many of their deductions 3%.

What this all means is that the higher the adjusted gross income is, the lower the chance there is for full deductions on many personal expenses and that means higher income taxes. We are now in the second-lowest federal tax bracket in history, but no one expects rates to decline or stay the same. Virtually everyone expects taxes to rise at a high rate. This makes limiting deductions even more damaging.

Higher taxable income pulls more and more middle-income taxpayers into the dreaded AMT category. One of the major components of the adjusted gross income line on your client’s tax return is income from a 403(b) or 401(k), IRA, or other retirement plan. A major consideration is the retirement benefits received every month from social security. There is a very strong possibility that part of your client’s Social Security check will be sent back to the IRS because their benefits end up being taxable for the year. Advisors can also explain that the client’s cost for Part B of Medicare rises as their adjusted gross income exceeds certain levels.

So, your clients may be paying more taxes than they expected to. The knowledgeable advisor can help the client by looking a how the retirement plan affects everything that’s taxable and all deduction limitations. Think of it this way; how would your client’s tax return look if they suddenly stopped receiving a monthly check from their retirement plan? It might pay to put a side-by-side comparison together to get the full impact for each of the next several years.

What are the benefits of converting an IRA, 401(k), 403(b), or any retirement plan to a Roth IRA, or Roth 401(k)/Roth 403(b)? All future income is tax-free if the rules are followed and if the client is qualified to do a conversion. Think about it; since tax-free income does not end up on your client’s adjusted gross income line, your client can avoid the problems of limited deductions and the hated taxation of Social Security benefits and stay out of the clutches of the AMT calculation. Didn’t your clients already pay taxes on this money when they were working?

By the way, as of 2009, a non-spouse beneficiary can convert a company retirement plan, such as a 401(k), to a Roth IRA by as long as the beneficiary can qualify. Many plans did not allow for this in 2009, but they will be mandated to do so starting in 2010.
It is easy to understand the benefits that a Roth conversion, but it’s is not for everyone for two reasons:
• It may not make economic sense.
• The taxpayer may not qualify.

Roth conversions come with a price tag, namely income taxes. Several factors affect the taxpayer’s decision to pay taxes on money pulled out of a retirement today or in the future. There are income limits that you cannot exceed during the rest of 2009. The modified adjusted gross income, for 2009, cannot exceed $100,000. Also, married persons must file jointly. There may be a way to manage the income in order to keep below the $100,000 threshold if the client wants a conversion during 2009 and income limits imposed on the taxpayer appear to be exceeded. This could be just a matter of managing income and expenses.

Those who are not absolutely sure whether the income limit will be exceeded should do the conversion anyway because it can be reversed if the actual income turns out to be too high. As far as the requirement for married folks to file jointly, maybe this can be done to facilitate the conversion for cases in which two married taxpayers normally file separately.

Once 2010 rolls around, all of these income limitations are removed. So anyone at any income level can qualify to convert a retirement plan (such as a 401(k) to a Roth 401(k) or Roth IRA or a company plan) to a Roth inherited IRA by a non-spouse beneficiary. One of the reasons that many people have not converted to a Roth IRA is that it would result in current-year increases in taxation. This would mean a much higher tax bracket as some itemized deductions could be lost and force Social Security retirement benefits into a taxable status as well as other considerations. Additionally, conversions done during 2010 will enjoy a delayed tax bill. The IRS will allow the income tax affect of the conversion to be spread over 2011 and 2012.

The professional advisor needs to be very aware of how Roth conversions work, how the client can benefit, what the tax consequences are, and how such a decision would fit into the client’s income planning, estate planning, and tax planning goals of.
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Thom Hunzicker, MBA CFP is the Principal of Generations Estate Planning in San Dimas CA. He writes articles for several area newspapers on estate planning and transition planning issues, and conducts public workshops and seminars. He can be contacted at (909) 599 9292. Please visit his website at www.nesteggdollars.com.