Client & Advisor Update - July 12, 2010

As with all financial decisions, a sober and rational analysis is required. Like any other tactic, a Roth IRA conversion is not a “silver bullet” and is not for everyone. It would make sense to consider it for clients sharing the following characteristics:

1. Have sufficiently large ordinary losses for 2010 and 2011.
2. Have enough cash outside the IRA account being converted to pay the additional income taxes on conversion.
3. Will likely be in the higher tax bracket in the future.
4. Are not concerned with the fickle nature of our tax system.

What Are the Advantages of Conversion?

The Roth IRA has several valuable tax advantages:

1. Income tax free growth;
2. Income-tax-free distributions (provided the account has been in existence at least five years);
3. No RMD (required minimum distributions) at age 70½;
4. Spousal rollover (same benefits to the surviving spouse); and
5. After the death of a spouse the non-spouse beneficiaries of the Roth IRA will continue to receive income tax free growth and distributions, though subject to a required distribution schedule based on their life expectancy

Looks like a great deal? Who wouldn’t want to “bullet proof” their retirement assets from the ravages of taxation?! The golden opportunity! TAX-FREE EVERYTHING! Well, not so fast …

Potential Disadvantages Also Exist

A closer look reveals the following:

1. Income taxes must be paid on the entire amount being converted.

Most rational people prefer to pay income taxes only when they have to. Conversion of a Traditional IRA account into a Roth IRA account is a voluntary acceleration of taxation. Almost invariably it only makes sense if your client has outside funds to pay the additional taxes. By way of example, assume a $1 million IRA conversion:

Income tax would amount to approximately $400,000 (assuming they live in a state with relatively high state income taxes). If your client does not have outside funds, he would have to distribute $667,000 from the IRA account to end up with $400,000 cash after taxes in order to pay the tax. This leaves him with just $333,000 to invest in the retirement account.

The actual amount of tax due would be affected by the taxpayers other taxable income. The balance of the IRA account being converted would be added to their other income, which may possibly have the additional effects of increasing the taxable portion of their Social Security benefits (for those who are already receiving them), as well as limiting itemized deductions and other tax return items.

2. The amount of income taxes is uncertain.

For conversions in 2010 there are two alternatives, either pay tax on the 100 percent of the converted amount on your 2010 return, or spread the tax liability over 2010 and 2011 tax returns. What to do? Do we know what tax rates are going to be in April of 2012 given current economic and political environment? The only silver lining on the taxation issue is the “re-characterization before October 15, 2011” option, which allows the client to undo the conversion. Consider the possibility that the Roth IRA loses money due to poor investment performance. If that happens, adding insult to injury, the client in retrospect ended up paying income taxes on the full amount and then ended up with less money in the account than they started with!

3. One small additional comment: investment returns are neither guaranteed nor are even accurately predictable for funds invested in the market.

Financial advisors project certain returns as a matter of discussion and to illustrate a strategy. Roth IRA will not earn more on the pre-tax basis than a Traditional IRA, it does not lessen nor does it eliminate investment risk. In fact, the overall risk is higher because the client pays income taxes upfront and now is obligated to show growth.

Are There Better Alternatives?

In our example the client would be well advised to evaluate possible alternatives before he or she parts with $400,000 in additional tax. Is there another more cost-effective way to invest your money than to give it to the government? What would produce better results? Life insurance may be this very option.

A quick primer on the benefits of life insurance:

1. After-tax contributions, tax-free growth, tax-free distributions! Looks like a Roth IRA so far, doesn’t it?
2. Tax-free death benefits (both income and estate tax free if structured properly outside of the estate)
3. Liquidity — during his or her lifetime, your client has an asset. The cash value of the insurance is mostly liquid and can be available for retirement income if desired.
4. Complete control as to how cash distributions are made.
5. Ability to structure the life insurance contract to link cash values with the stock market performance.

Conclusion

There is a lot of attention this year being paid to the idea of Roth IRA conversions. The strategy is not for everyone, and will only makes sense if:

• The income taxes are paid with outside funds; and
• The client is otherwise uninsurable