Converting to a Roth IRA Is no Easy Decision

December 21, 2009

Beginning January 1, 2010, just days from now, the income-earning restrictions will be lifted from Roth IRAs. Physicians will then be able to convert retirement funds from traditional IRAs over to the Roth IRA. Sounds like a sweet deal, right? Well, maybe not.

Since it was created in 1997, the Roth IRA has enabled individuals to stash away after-tax contributions while working in exchange for the ability to take distributions tax-free upon retirement. The caveat, however, was that the Roth IRA contained income limitations that made it virtually impossible for physicians and other high-income earners to take advantage of its tax protection aspects...until now, that is.

Beginning January 1, 2010, just days from now, the income-earning restrictions will be lifted from Roth IRAs. Physicians will then be able to convert retirement funds from traditional IRAs over to the Roth IRA. Sounds like a sweet deal, right? Well, maybe not.

“My general sense is that less than 25 percent [of those eligible for the conversion] will do it,” says Dean Barber, founder and president of the Barber Financial Group and host of the radio program “America’s Wealth Management Show,” which airs in 17 cities. “If you don’t have money outside the IRA, the conversion doesn’t make sense.”

Bad timing?

Part of the problem with converting to a Roth IRA is that taxes will have to be paid on the conversion amount. That payment, agrees Raymond Russolillo, CPA/PFS, CFP, a partner with the accounting and consulting firm of Eisner & Lubin LLP, should be made with funds outisde of an individual’s IRA—a strategy that might have been easier to follow two or three years ago before the slumping economy ate away many individual’s savings. In addition, making a substantial tax payment now goes against many tax principles that preach to delay the paying of taxes as long as possible, and only pay them when it’s absolutely necessary.

“For some folks who might have a seven- or eight-figure IRA, you’re talking big dollars to write a check,” Russolillo says. “Even for some people who [the conversion] might make sense for, it’s going to hurt too much to write that check to the government.”

There are other considerations as well. Although the tax on conversions made in 2010 can be paid in two installments with the 2011 and 2012 tax returns, somewhat easing the immediate hit on personal finances, Barber says it’s important to consider the bigger picture long-term. He explains that by converting, an individual’s adjusted gross income might rise to a point where they can no longer claim their children as dependents, or where they’re unable to itemize on their tax returns.

Consider the benefits, too

Of course, that doesn’t mean the opportunity to convert to a Roth IRA is all gloom and doom. Barber explains that every IRA or 401(k), with the exception of the Roth, has a mortgage on it. That mortgage is held by Uncle Sam. And the problem with that mortgage is that there’s no way of knowing how much it’s going to be until you take the money out. Paying the tax now, at a known rate, might make sense.

In addition, there’s what Bradley Bofford, CLU, ChFC, managing partner with Financial Principles, LLC, calls the do-over clause. “If the market does poorly after the conversion in early January 2010, you can also take advantage of recharacterizing the conversion.” He adds that if a physician does not foresee needing to use these funds whatsoever, the Roth IRA does not have Required Minimum Distributions (as does a traditional IRA at age 70-1/2). “This can be an excellent estate planning technique to pass along greater assets to heirs on a much more tax favorable basis.”

Also, says Russolillo, the opportunity to convert to a Roth IRA is not a one-shot deal. If a physician can’t afford to convert in 2010, he or she can still do so in 2011 or 2012. The only difference is that if you don’t convert in 2010, you lose the option to pay the tax over a two-year period. Instead, the tax would have to be paid during the current year.

Is it right for you?

Every physician’s financial situation is different, so it’s important to consider whether converting to a Roth IRA makes sense for you and you alone. As Barber points out, the amount of work that has to be done to truly make an intelligent decision on the Roth conversion is enormous. And he suggests that before undertaking a Roth conversion analysis, it’s critical to have a written financial plan in place. Unfortunately, he adds, less than 10 percent of the population has such a formalized plan.

“If I’m 55-years old and heading toward retirement, I should know the probability of success of achieving my retirement goals, based on where I am today, what I can save, and my assumption for tax rates, pensions and Social Security,” Barber says. “Once I know the probability of achieving all of my financial goals in retirement, only then can I overlay the Roth conversion analysis on top of that to determine how it will affect my probability of success.”

So much for the conversion being a no-brainer.