Quote of the day

Loading Quotes...


Roth Conversion Fail

If you read any financial blogs or magazines, there’s no getting away from one topic. The Roth IRA, and the Roth conversion in particular. I continue to write about this because I think the choice isn’t always so clear cut. It’s rarely a “no-brainer” to convert and be certain it was the right decision.

I read and recently rediscovered an article in Kiplinger magazine titled “How to Finance a Roth Conversion.” Sorry, that title alone is enough to scare me. It implies a number of things. First, this couple in the article aren’t particularly liquid, they don’t have enough to pay the taxes on the conversion out of pocket. Second, they plan to convert so much that there will be a big tax bill. In fact, the amount they are considering converting is $250K, and it will result in a $100K tax bill, putting them into the 35% bracket. One planner advises that they proceed with the conversion splitting the income over two years on their tax return. This would make the first bill (say $50K) due in April 2012. He says they need to just save about $2K/mo from now until then, to pay this tax bill. He ignores the potential penalty and interest for underwithholding, and does a better job ignoring the next $50K bill that would be due only 12 months later.

Another planner thinks this couple should convert a bit at a time and pay [taxes] as they go. A more level-headed approach I’d say.

For this couple, the question of conversion is motivated by “higher taxes are coming.” Now, that may be, I really can’t say. One thing that does go in this couple’s favor is that they are both government employees. They are in a group that tends to have a better pension than most. Many public companies have discontinued their defined benefit plan, in some cases stopping further accrual, in others, cashing out their employees with a transfer to an IRA account. The question that remains for me regarding this couple, who are in their thirties and have an infant daughter – what do thing the chances are that you will both remain employed, full time, from now until the day you retire? Robert Burns’ To a Mouse contained the line “The best laid schemes o’ mice an’ men / Gang aft agley.” I wish this couple well, but a lower bracket between now and retirement isn’t necessarily due to a negative event. Maybe one of them wishes to stay home for a period after the birth of their next child. Maybe a new position becomes available in a state that has no income tax and they avoid the near 6% Virginia state tax. Time will tell, of course, this is just one example of those who are rushing into a decision I believe they’ll regret. Next week, I’ll offer an alternate approach that would save this couple quite a bit on their taxes.

Joe

  • Joe Arsenault July 21, 2010, 11:05 pm

    I agree with you Joe. There are many advantages to a Roth, it is more efficient through your estate, no RMDs for original owners, etc. It is not for everyone though! You said it best, if someone is considering financing the conversion, liquidity is probably an issue, that is most likely not a great scenario. I do not want to spam you and leave a link to any of my resources, but I do a lot of work in this area, I do seminars and work with about 500 advisors that deal with this stuff from a tax standpoint. And with that I say, nice work! 🙂

    One separate note, a planner that is advising a large conversion needs to keep in mind protective estimates for state income tax, as this is an AMT add back. Some will get caught sleeping without good advice and planning. Robert Keebler has a great book that goes over this.

    Thanks for a nice piece. I will check out your related posts as well. It is refreshing to see this topic not get battered by authors who don’t understand the subject matter.

    -Another Joe

  • Joe Arsenault July 21, 2010, 11:32 pm

    Agreed again.. It seems the most common case where a Roth Conversion is a positive option is when the clients do not want RMDs and just want to pass it through their estate to their kids. This of course usually means much larger dollar conversions which requires more of a microscope.

    Some people seem to think the Roth is a brand new product, like you said, Mania!

  • JOE July 21, 2010, 11:28 pm

    Much appreciated. I think Roth Mania has become too common, and while it’s tough to pin down a number, I’m guessing fewer than 15% of retirees will find themselves in a higher bracket after retiring.

  • kern July 26, 2010, 1:16 am

    Joe(s),

    I am interested in what you said about the protective estimates of state income taxes and the “AMT add back” .. You are saying that with a large conversion, increasing your AGI and subsequently deducting your state income tax, the AMT will go up as the state tax deduction is added back to the total, correct?

    Also, what do you think about tax diversification, where it is possibly beneficial to have different ‘buckets’ of retirement funds to dip into, with one unique bucket having Roth money in it? I did a couple Roth conversions back when my marginal tax rate was lower – 25% and state tax of 5%. and paid the tax on it at the time from other funds. I now am in 33% fed & 9.3% state rates and will not have any opportunity to convert again until I am retired I suppose.

    Great post!

  • JOE July 26, 2010, 7:23 am

    State tax is one of the little discussed wild cards in this discussion. You are at 9.3% state now. Who can say where you will want to live in retirement? The chance you move to a lower tax state (or no-tax state) shouldn’t be ignored.
    The AMT impact deserves a post of its own, but let me offer, TurboTax is great for the “what-ifs” – I set up a return that would put a couple just into the 28% bracket (over $137,050 taxable in 2009). But when I add income, the next $1K is taxes at $325 due to AMT. The adviser suggesting conversions who only looks at marginal rates does a disservice to the client. So lond as when you say you were in the 25% bracket you meant that $10K of conversion increased your federal tax $2500, you did just fine.
    This topic leaves much room for further exploration, at least a few more posts to come.
    Thanks for visiting and writing today.
    Joe

Leave a Comment