RISK VERSUS REWARD

If you have had a chance to read previous Virtus View's and The Virtus Wealth Management Quarterly Newsletters, you know that I am a proponent of converting IRAs to Roth IRAs in most cases.  However, it must be pointed out that Roth conversions are not for everyone.  Unfortunately, based on what I am hearing from individuals out there, those that think Roth conversions are not for them are usually wrong and in some cases those that are convinced a conversion is for them, are making a mistake.
 
First, let's summarize the opportunity.  Tax laws were written to give investors an opportunity to convert IRAs to Roth IRAs in 2010 without the income cap.  Previously, if your AGI was greater than $100,000 you could not convert your IRA.  Roth IRAs are different than traditional IRAs in that they are not taxed on distributions, do not require RMDs (required minimum distributions at 70 ½) and are more favorable in Estate Planning.  On the other hand, Roth IRAs do not provide the first year tax savings like traditional IRAs.

 
So to help clarify this very important opportunity, following are the 5 most common mistakes I have seen investors make in determining if a Roth IRA conversions is for them:
 
1.      Not Planning - The tax laws for the Roth Conversions are complex.  You can pay all the taxes in the current year or have the taxes paid over a two year period in 2011 and 2012; however what most do not realize is that the income from the Roth IRA conversion goes into the year in which you are paying the taxes.  Thus, if one is converting $100,000 and decides to utilize the two year payment option, $50,000 is counted as income in 2011 and $50,000 is added to your income in 2012.  Thus, deferring is not always the best option.  There are other items needing careful planning, thus just converting without a detailed analysis of the options is dangerous.  You will see that if the number one mistake is avoided, the rest of these common mistakes will be avoided also.

2.      Not Understanding Re-Characterization Rules - An individual may re-characterize a Roth Conversion if the market has a major correction.  For example, if you convert $100,000 and the market drops to a point where that Roth IRA is now only worth $50,000, you can re-characterize that Roth IRA back to a traditional IRA.  Why would one want to do that?  Assuming a 20% tax bracket, your tax liability upon converting the $100,000 is $20,000.  However, if you re-characterize that Roth IRA back into a traditional IRA and then covert at a later date (now that the value is $50,000) your tax liability drops to $10,000 as opposed to the $20,000 if nothing is done.

3.      Having Taxes Withheld from the Conversion - You have the option once you convert to have taxes withheld from your conversion.  Thus, if you convert $100,000 and request that 20% be withheld for taxes, your actual conversion is only $80,000.  The problem with this relates to mistake #2.  If you want to re-characterize at a later date, you will only be able to re-characterize $80,000 since that is the official conversion amount.

4.      Believing Nothing Can Be Done To Lower Your Tax Liability - We have 3 different options, or a combination of any of the 3, to help lower most clients tax liability of doing a conversion.  In many cases, the financial difference between doing a conversion and not doing one is not large; however by lowering your tax liability it may make a Roth Conversion much more attractive.  And quite frankly, how many of us want to pay higher taxes?

5.      Using an existing Roth IRA to convert into - A Roth IRA conversion should utilize new Roth IRAs instead of existing Roth IRAs.  With the volatility of the current markets, it may be prudent to re-characterize a Roth conversion at a later date.  Thus, if we convert into several different Roth IRAs with each one being invested into a different major asset class, it will provide us with the most downside protection.  We can always consolidate all of the Roth IRAs after the re-characterization deadline.
 
Obviously there are more mistakes out there; these are just some of the most major errors I see being made by individuals looking to convert to a Roth IRA.  If the number 1 mistake is avoided, the rest should be as well.  If you are considering a Roth conversion, let us help you with the planning and methods to possibly reduce your tax liability.  For more information on ROTH Conversions, a good source is the IRS Website, www.IRS.gov.