Many financial marketing companies are gearing up to promote the benefits of Roth conversion 2010. This is a great opportunity for advisors to gather new clients and assets and increase revenues. But if you stop to think about it, if every marketing company is promoting the “positive benefits,” who is talking about the “negative benefits”? Most of the questions to ask the client come from their tax return.
Beginning Jan. 1, 2010, everyone became eligible to convert their deductible and non- deductible IRAs to Roth IRAs; in 2009, investors could only convert from a traditional IRA to a Roth IRA if their adjusted gross income (AGI) was less than $100,000.
If your clients convert their traditional IRAs in 2010 to a Roth IRAs, they can spread the taxes over a two-year period. For example, if they convert a $50,000 traditional IRA to a Roth IRA, triggering a liability of $15,000 in federal income taxes, they could choose to pay $7,500 in 2011 and $7,500 in 2012, instead of the entire amount in 2010.
What to consider before converting
However, there are certain considerations your clients should take into account before making this switch — and as their insurance advisor, you should be equipped to counsel them on these potential issues.
- A possible increase in current federal and state tax brackets. Be aware that any money converted from a traditional IRA into a Roth IRA could increase the investor’s tax bracket.
- How will they pay the taxes? Are they going to pay these taxes from earned income, such as wages, or from interest or dividends? Would they have to take distributions or loans from their 401(k) plan (which, by the way, is a terrible idea)? Would they have to sell some of their long-term investments to pay the taxes (another terrible idea that could generate more taxes)? If your client is thinking of paying the tax from the Roth conversion, they are defeating the purpose. In addition, if they are younger than 59½, they will pay a 10 percent penalty.
- The investor may have to make estimated tax payments. If your client has a significant increase in taxable income with no withholding, they might need to make quarterly estimated payments to the IRS. Failure to make timely estimates could result in penalties and interest.
- Their Medicare Part B premium could increase. In 2009, most people paid a monthly premium of $96.40 for their Medicare B premium. However, some paid a higher premium because Medicare B premium is based on the policyholder’s income. A Roth conversion could cause your client’s total income to rise, which would increase their modified adjusted gross income (MAGI). Therefore, this could cause their Medicare Part B premium to increase as much as hundreds of dollars a month. However, this would only be for a year or two.
- They could lose personal and itemized deductions. Adjusted gross income (AGI) increases above certain amounts could cause a reduction in or elimination of certain itemized deductions and personal exemptions.
- Eligibility for college financial aid and scholarships could be affected. An increase in a parent’s income could reduce their children’s eligibility for financial aid and scholarships.
- Tax credits could be reduced. Tax deductions help reduce your client’s taxable income, and a tax credit reduces their tax liability dollar for dollar. However, many of these tax credits are based on adjusted gross income (AGI). In some cases, their tax credit could be reduced or carry forward to the next tax year.
- Alternative minimum tax (AMT) could be affected. By converting to a Roth IRA, you could be subject to the very outdated AMT. The AMT is a second tax system with different rules and rates. The rules and rates are usually less generous than the regular tax system.
Who should convert?
So given all these pitfalls, what benefits might a Roth IRA conversion offer?
- Relief to those in lower tax brackets. With the unemployment rate topping 10 percent, many people today could fall into a lower tax bracket. While your client is in a (hopefully temporary) lower tax bracket, it could be a good time to convert their traditional IRA to a Roth. They might want to pay all the taxes in 2010 to take advantage of a lower tax bracket. However, they could also still spread the taxes between 2011 and 2012.
- Application of losses from a bad business year. Your client might have had some big losses for the year, either through self-employment or from owning a corporation. Those losses could help offset some of the taxes owed on a Roth IRA conversion.
- No required minimum distributions. Individuals older than 70½ must usually take required minimum distributions (RMDs) from their traditional IRA. In 2009, investors were not required to take a RMD. However, in a Roth IRA, there are no 70½ RMD requirements.
- Increased inheritances to children or grandchildren. By paying the taxes now on the Roth conversion, your client’s children and grandchildren could inherit their Roth IRA account without having to pay income taxes.
- Getting a “do-over.” If your client’s account declines in value after they convert, the tax law allows them to re-characterize their account and switch their Roth IRA back to a Traditional IRA.
- Time is on their side. In general, if your client has a 10 to 15-year time horizon before they plan on taking distributions from their account, a Roth IRA could offer them tax-free growth.
So know the pitfalls, and know the benefits — because the day will come when you client will ask you about Roth IRA conversion. And it may be sooner than you think.
Brian R. Gilder is the owner of Gilder Financial Management. He can be reached at 310-804-3767 or brian@followthetaxreturn.com.