IRA Conversions: Tips and Traps

Christine Benz: I'm Christine Benz from Morningstar. I'm here at the Investment News Retirement Income Summit. I'm happy to say that I'm joined today by Natalie Choate. Natalie is the author of "Life and Death Planning for Retirement Benefits." She's also one of the foremost retirement planning experts in the country. Natalie, thank you so much for joining us.

Natalie Choate: My pleasure, Christine.

Benz: So, one interesting opportunity that has emerged for retirement planning this year is the lifting of income limits for IRA conversions. You have written a lot about this topic, you had a great piece on key tips and traps to avoid. So let's start with the tips, some things to think about when you are trying to determine whether you are a good candidate for a conversion.

Choate: All right. I think everybody who has a plan or an IRA is now wrestling with this: "Should I convert to a Roth IRA?" It's a tough decision to make, so I'm going to try to make it a little bit easier by one tip, which is that everybody who is in this room, everybody who is watching this, should open a small Roth IRA now, today, if you haven't done it already.

There's two reasons for that. One is that you're going to get your five-year clock started by doing that. Roth IRAs are famous because they have tax free distributions, but actually the distributions aren't always automatically tax free. Your earnings that you get inside the Roth IRA are tax free only if you've had a Roth IRA in existence for five years.

Benz: OK, so starting now, get set, clock running.

Choate: Right! You may be convinced you never want to convert to a Roth IRA but maybe 10 years from now you might change your mind, and if you opened a Roth IRA today you've already passed the five-year clock for your future conversion that you might do.

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Benz: OK.

Choate: The second reason to do it today is I suspect there might be a year-end rush this year on Roth conversions. As you pointed out the ceiling has been lifted this year so why isn't everybody rushing to do this? It's hard to decide; people are uncertain. But one thing that will make a Roth IRA conversion profitable is if your tax rate goes up in the future. Tax rates are scheduled to go up in the future, starting next year when the so called "Bush tax cuts" expire. And if Congress does nothing, they will go up. I have a feeling that if Congress does nothing, along about Thanksgiving people are going to start focusing on this and saying: "My tax rate really is going to go up."

Benz: What can I do?

Choate: Right. And there may be a rush for the exits at that point.

Well, there's two steps to doing a Roth conversion. You open the Roth IRA and then you transfer money into it from your other traditional plan. If you've already done step one and opened the account, then if you get that year-end urge to do more, you've made it easier for yourself. All you have to do is just transfer some more money into it.

Benz: OK. So getting started now is a key tip. Any other things to do right now or things to think about in terms of whether this is an appropriate move for you?

Choate: Whether it's an appropriate move for somebody? Well, the numbers guys tell me there's four factors. If you can guarantee these four factors will exist, then it's guaranteed to be a money maker for you.

1. Your tax rate is going up in the future.

2. You can leave that money in for a long time, either during your retirement years or over a beneficiary's life expectancy.

Benz: How long is long? I know that it really depends, but...

Choate: Well, the longer the better but if you know you have to take it out next year, it's not worth doing, but five, 10, 20, 30 years, then we're good.

Benz: OK.

Choate: 3. You've got to be able to pay the tax on the conversion using outside-of-the-plan dollars.

Benz: Not the IRA assets themselves.

Choate: Right. Right.

4. And the fourth is that your investments go up, which nobody can guarantee. So...

Benz: Let's talk about some of the key traps that you want to think about if you are considering a conversion. So obviously pulling the money out to pay the taxes is a bad idea.

Choate: That would be a trap, yes. When you fill out your form to do a conversion, there's a little box you have to check to say: "I don't want income taxes withheld." Big trap, if you don't check that box you're going to find some of the money went to the IRS.

You've got to name a beneficiary for that Roth IRA you create, even if you're sure you're going to undo the conversion next year. You could die in the meantime. You need to have a beneficiary on that account.

The worst trap for a Roth IRA would be to commit a prohibited transaction with your Roth IRA. That would be like buying or selling assets to your Roth IRA, renting an apartment to your kid or something in your IRA-owned investment. That disqualifies the Roth IRA and makes all the distributions taxable to the extent that you exceeded your contribution. It's like the death penalty plus being condemned to hell forever.

Benz: OK. Bad. [laughs]

Choate: Very bad. Yes.

Benz: So, Natalie, I know there had been a lot of talk that there would be this stampede to convert. It doesn't seem, anecdotally at least, that there has been, but it sounds like you think that interest will pick up as there becomes concern about some of these Bush tax provisions.

Choate: Absolutely. Right. Now, maybe Congress will erase those tax increases so tax rates aren't going to go up and everybody can coast along another year, but if these tax rates are really going to happen, and it looks that way at the end of the year, there's going to be interest in this. But maybe the best thing about this year's opportunity is that it's going to force all of us to talk with financial advisors and really plot out what our income needs are going to be, what our tax rate is going to be, what our investment return is likely to be. Even if you end up not doing a conversion it's good that we're being compelled to have those conversations.

Benz: Well, Natalie, great insights as always. Thanks for summing it up for us, and we appreciate you being here.

Choate: You're welcome, Christine.

Benz: Thanks for watching. I'm Christine Benz.