An adviser told me I can save 35% of the taxes on a Roth conversion. Is that true?

By Beth Pinsker

The age-old rule applies: If it sounds too good to be true, it probably is

A financial offer out of the blue should be the first thing to raise red flags.

Got a question about investing, how it fits into your overall financial plan or what strategies can help you make the most out of your money? You can write to me at beth.pinsker@marketwatch.com. Please put "Fix My Portfolio" in the subject line.

Dear Fix My Portfolio,

An adviser contacted me recently about doing a Roth conversion. He recommended doing a one-time lump sum conversion of a 401(k) using a self-directed IRA with an LLC. He said I can then use a depreciation factor of 35% on the amount converted to a self-directed Roth IRA, so I'd only be paying taxes on 65% of the amount converted. I told him that the 401(k) contains mutual funds and didn't think I could use depreciation on that type of asset - it could only be used on alternative investments like real estate, oil and gas exploration, etc. However, he claimed I could use it. Does that scheme he suggested sound legit? I'm skeptical.

Concerned

Dear Concerned,

I should call you Rightly Concerned. You are in big red-flag territory for this one. First of all, you started by saying "an adviser" contacted you, not your adviser. Anybody making a financial pitch to you out of the blue likely has ulterior motives. That means they are going to make money on their end in some way, likely from commissions, while your piece of it may not be to your best advantage. At least get a steak dinner out of it!

The second thing is that an adviser was proposing a Roth conversion to you at all. This should be baked into your long-term financial plan. It's something that should have come up at your onboarding with the financial planner, even if you signed up with them a long time ago and retirement was only a twinkle in your eye. Roth conversions are about tax efficiency, not getting rich quickly. At the very least, it would be something you discuss during several regular meetings when you update your plan. How you have your retirement funds allocated between traditional and Roth accounts is not something that comes out of the blue.

Third thing: The adviser suggested a lump-sum conversion. This is generally considered a big no-no in the financial-planning world. It can work for some people who prefer the "pull off the Band-Aid approach," but for most, smoothing out the tax consequences works best.

"Lump-sum conversions are generally inadvisable because, depending on the amount of the lump sum, converting a large amount in a single year can push you into a much higher bracket than you'd otherwise face," explains Eli Dorf, a certified financial planner with Clearfront Advisory in Boston.

If you have a large enough sum in your traditional 401(k) to attract this kind of fishing expedition from an adviser, the tax on a lump-sum conversion could be enormous. Say, for instance, you have $1 million. That would add to your taxable income for the year, and almost all of it would be at the 37% tax bracket. You'd owe roughly $370,000 to the IRS. Now, you might have that cash on hand, and plenty more, but you'd pay less tax if you converted smaller amounts over several years and paid tax in a lower tax bracket; the 24% bracket would be considerably better.

If your sketchy adviser suggested paying the tax for the conversion out of the $1 million itself, I'd raise another red flag. Most advisers caution clients against this because it defeats the purpose of the conversion. Instead of converting $1 million into an account where it will grow tax-free and be more easily managed by heirs because they won't owe tax on their inheritance, you'd be converting $630,000. The growth difference would be noticeable.

You can't escape conversion taxes

Now let's get to the depreciation element, because this is the key selling point made to you. You were right to be skeptical.

"There is simply no depreciation deduction available to apply at the moment of a Roth conversion, regardless of what investments are inside either the Traditional IRA or the Roth IRA," says Dorf.

As with most financial offers, if it sounds too good to be true, it likely is. When you take money out of a pretax retirement account, you owe tax on it. The purpose of tax-deferred money is to entice people to save, and the benefit to you is that you can put off paying the tax on that money until you retire and, presumably, are in a lower tax bracket. This is not always the case, but it's the more common scenario. Eventually, the government wants its cut. There's no easy loophole.

Depreciation may come into play if you convert your 401(k) to a self-directed Roth IRA and invest the funds in something like oil or real estate. But in that case, it would be defeating the purpose. Once your funds are in the Roth, depreciation of the assets doesn't matter because your growth is tax-free. Advisers typically recommend putting your highly appreciating assets in these accounts because you don't have to worry about capital gains and dividends. I'd go back to the drawing board on this one and plot out a rational plan for Roth conversions over several years, if that's what you decide makes the most sense for you. If you talk to an adviser about your strategy, make sure you are formally engaging them and that they are a fiduciary bound to give you advice that is in your best interest. You're the one who wants a trip to a fancy resort out of this deal, not the adviser getting bonus prizes for signing a new deal.

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-Beth Pinsker

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