Avoid these Roth IRA conversion mistakes

BOSTON — While most of the four in 10 U.S. households that own an IRA don't plan to convert those accounts to Roth IRAs this year, thousands are deciding to take the conversion step — and many are making some astonishing mistakes that experts say could be avoided easily.

More than a few investors have made after-tax (nondeductible) contributions to their IRAs or qualified employer plans over the years. With deductible contributions, you avoid paying taxes on the contribution amount until distribution at a later date.

With after-tax contributions you include the contribution amount as part of your taxable income in the year contributed, but then get to withdraw the contribution amount (basis) tax-free at a later date.

When taxpayers who have made after-tax contributions decide to convert savings from a regular IRA or employer-sponsored plan to a Roth IRA, the investor is generally able to avoid taxes on the part of the conversion that represents after-tax basis.

But that's not what IRA owners and their advisers are doing, according to Ben Norquist, president and CEO of Convergent Retirement Plan Solutions.

"We continue to see individuals with after-tax basis and their advisers who fail to take advantage of the various strategies available for doing a Roth IRA conversion at the lowest cost," Norquist said. "By not being aware of the options available to them, many individuals continue to incur a larger-than-necessary tax hit when doing conversions where after-tax basis amounts are involved."

Another mistake: IRA owners look at Roth IRA conversions as an all-or-nothing proposition.

"While 100 percent conversion may make sense for a small minority of individuals, we continue to believe that the majority of investors would be best served by considering a partial conversion as a means of diversifying their overall tax risk," Norquist said.

In fact, he said, two things need to occur within the financial-services industry for the Roth alternative to be used in a rational manner:

• The industry needs to get a better handle on the real math behind the conversion decision and quit reinforcing overly simplistic rules of thumb such as, "You should only convert if you anticipate being in a higher tax bracket in retirement."

• The industry needs to get away from thinking of the Roth conversion option as an all-or-nothing decision and begin focusing on partial Roth IRA conversions as a legitimate tax-hedging strategy.

Reluctant, confused

Many custodians are reluctant to do conversions of employer plan assets, said Beverly DeVeny, an IRA technical consultant at Ed Slott and Co.

"They want the assets in an IRA first and then will do a Roth conversion," she said.

For the record, plan participants can do a Roth conversion from their employer's plan.

The other problem that's occurring out in the real world with custodians, according to DeVeny, has to do with the conversion of after-tax amounts.

"The IRS has yet to release any meaningful clarification on this topic and many plan administrators have not changed the advice that they have been giving plan participants for the last three or four years," she said.

IRA owners seem to be focusing entirely on one slice of the tax pie with Roth IRA conversions, instead of the entire tax pie. That's a mistake, said Robert Keebler, a certified public accountant, partner at Baker Tilly Virchow Krause, and author of "The Rebirth of Roth: A CPA's Ultimate Guide for Client Care."

IRA owners need to examine what he calls the incremental effective income-tax rates, the alternative minimum tax (AMT), the new 3.8 percent Medicare surtax, and the estate-tax and post-mortem distribution issues.

"Perhaps the most misunderstood factor impacting the decision of whether or not to convert is the appropriate income tax rates to use for the conversion year versus the future tax years," Keebler wrote in a report.

"While choosing an appropriate income tax rate for future tax years is more of an art than a science, choosing an appropriate income tax rate for the Roth IRA conversion in the conversion year is much more analytical. When analyzing a Roth IRA conversion, one cannot simply use a 'marginal' income-tax rate to determine the income tax liability," he wrote.

"This oftentimes results in a higher tax liability on the conversion than what would otherwise actually be incurred. Other than for taxpayers already in the highest marginal income tax bracket (i.e. 35 percent in 2010), most conversions will 'slide' through various tax brackets. Thus, one must look at the 'incremental effective' income tax liability caused by the conversion," Keebler wrote.

Also, Keebler said AMT can pose a problem for the unaware. "One of the most perplexing issues encountered when analyzing Roth IRA conversions is the impact that the AMT, and any of its related tax credits, has on the conversion decision," he wrote.

"Interestingly enough, while the AMT is something that certainly needs to be considered, most taxpayers (and their advisers) only look at Roth IRA conversions from an ordinary income tax perspective. As a result, many times taxpayers are lulled into believing that a Roth IRA conversion makes sense when in fact it may not make sense from an AMT perspective.

"Conversely, there are instances when taxpayers are led to believe a conversion does not make sense, from an ordinary income tax perspective, when it actually does make sense from an AMT perspective," he wrote.

Medicare surtax

And though not a mistake, Keebler also said taxpayers now must consider the new Medicare surtax. The Patient Protection and Affordable Care Act and the reconciliation bill added a number of new tax provisions to the Internal Revenue Code. Perhaps the most significant change from a tax-planning perspective is a new 3.8 percent surtax on the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount, according to Keebler.

That tax, when combined with the expiration of the Bush-era tax cuts in December 2010, will move the highest marginal rate from 35 to 43.4 percent. Given that, Keebler is of the opinion that Roth conversions from 2010 through 2012 will help many taxpayers reduce their exposure to the new surtax.

In addition, for those potentially subject to estate tax, there can be significant tax advantages to converting to a Roth IRA prior to death, Keebler said. "When modeling Roth IRA conversions, one must factor in the potential impact that estate taxes will have on the conversion equation," he said.

Though a bit complicated, the gist of it is this: When a taxpayer with a regular IRA dies, the estate or the beneficiaries end up paying income tax on what's called income in respect of a decedent (IRD).

The good news, according to Keebler: "To the extent that a decedent's estate is subject to estate tax, the decedent's estate (or its beneficiaries) will be an income tax deduction for the federal estate tax paid on the IRD."

Many IRAs owner apparently fail to crunch the numbers when doing the Roth IRA conversion calculation.

"One of the points we make with advisers is to not overstate the offset value of the IRD deduction," Norquist said. "Whereas the Roth conversion scenario can result in immediate tax savings at the time of death in the form of reduced estate-tax liability, the IRD deduction for beneficiaries with respect to traditional IRA assets will generally be recovered gradually over multiple decades (assuming the beneficiary is taking minimum distributions), thereby decreasing the overall net present value of the IRD deduction."

In short, he said, "The estate-tax implications of a Roth conversion are potentially significant."