Thursday, July 29, 2010

RSY IV...Roth Conversions.

Very shortly we will be publishing our Rock Solid Yield portfolio here at The Sabrient Blog. But before that, I wanted to address an issue outside of the normal dividend yielding stocks issues but an issue that is still important when considering long term investments. In this post I want to cover some of the problems when converting a retirement account to a Roth IRA. The impetus for such an interest was a couple of recent articles that downplayed the benefits of a Roth conversion.

The first article is from Market Watch at Why You Shouldn't Convert to a Roth IRA. Annie Gasparro provides 5 important reasons why someone would not want to convert.

1. The tax bite is too big.
It more than likely is too big if there is not extra funds available to pay for the additional tax burdens. But considering that for 2010 tax year the burden can be divided up in 2011 and 2012 then it still might be worth considering how to pay the additional taxes. Another consideration is to think about the actual tax burden you face today versus an uncertain future. For example, the Making Work Pay Tax Credit helps reduce the tax burden for two years for middle to low income earners. There are a multitude of reasons that present income and thus marginal tax rates might be lower now and thus an important consideration when deciding the best financial moves now and in the future.

Along with taxes it is important to consider any effects it will have on benefits. Robert Powell provides some important considerations also at 12 traps to avoid when converting to a Roth. The two points that relate to the benefits side is first it might alter your Medicare costs and Social Security taxation rates and it may affect family eligibility for financial aid. Both have more to do with life cycle decisions and thus more to do with timing of conversions.

2. Retirement is too close.
The scenarios all point to very little to no benefit for near to retirement or retired individuals or couples. The one outside move is to do it for purely bequeaths motives to help benefactors in their tax issues. Fidelty also notes the importance of time to reap the full benefits of conversion as one of 3 considerations.
2. Timeā€”The relative benefits of conversion will increase the longer your money remains in the Roth IRA. Generally, conversion may not make sense if your time horizon is less than five years as amounts withdrawn are subject to a 10% penalty. {Factors to weigh when considering a Roth IRA conversion}


3. The investor's savings are too concentrated.
This is another aspect of age. It is a lot easier for a young person to start planning for retirement and then adjust so that not all his/her eggs are in one basket. Gasparro does point out that partial conversions might be a good compromise but also there are other ways to reallocate assets and consider ways of diversifying income streams. For example many are considering partial retirement now as a result of the recent financial crisis. That is working part time that will pay for most bills along with SS checks and then that allows delaying the time to take out retirement funds. This would reduce the penalties for concentration indirectly.

4. Tax brackets often change in retirement.
True, it is expected that income tends to be lower in retirement age, but there is something to be said for the Federal debt is getting out of hand and that marginal tax rates are likely to "creep" higher and affect people in lower income brackets over time. This uncertainty each of us as individual investors must address. Although on the counter argument, there could be a shift from income tax burden on society to more of a consumption tax which would favor the traditional choice over time. But that scenario of a value added tax is hard for me to see it coming to full fruition.

5. The income can change your tax bracket now.
Again, if someone is close to or is of retirement age then a Roth conversion is not likely to make sense unless for bequeathment purposes to individuals. These issues are addressed in the second article to catch my attention from the Wall Street Journal titled Is a Roth IRA Safe From Taxes? Along with addressing the issues of estate planning, Laura Saunders also talks about tax burden changes and the VAT and the headline issue of whether social contracts are secure in the face of budget constraints. The last seems more like a headline searching for a controversy. Because ultimately Congress could in fact do anything if the Roth rules and regulations are for naught. In fact I can think of many ways they could in fact make any choice we make now merely random decisions. Take for example taxing Traditional IRAs at double the tax rates. Makes as much sense.

The Generalities Sound Great but What about My Situation?
There is no definitive answer for any individual as there are risks and uncertainties about the future but I did explore three web sites that provide a questionnaire and results that can help determine if the Roth conversion is right for you.
1. Fidelty-Convert to a Roth IRA Factors to weigh when considering a Roth IRA conversion

2. Roth IRA Conversion - T. Rowe Price

3. Should I Convert To A Roth IRA? - Financial Calculators from CalcXML

Ultimately, you may want to consult a tax specialist. Also a tax software package may provid valuable information even if you do not use them to file with. Last year before converting, I used a tax program and entered my estimated incomes without any deductions and got a rough estimate of the highest possible taxes and then experimented with different amounts of dollar amounts converted {partial conversion rates}. After being happy that I could afford the conversion, I went ahead and did a partial conversion.

It might be helpful to try the various tests above with different scenarios and see if one provides a tilting point to when a decision to convert transitions from positive to negative. Each of the questionnaires have a slightly different algorithm for analysis so looking at the questions and determining the underlying assumptions might be a way to see which scenarios would fit your expectations more closely. For myself, all the tests resulted in positive results from the conversion but varied to the amounts of benefits as expected with most providing clear signals to the upside benefits.

At 7 Things To Know About The 2010 Roth IRA Conversion Rules, Jeff Rose touches on issues related to cost basis. This is important to keep in mind even if your broker will provide this information as stocks can also be converted. For example a person could covert the stocks that have done poorly recently but are expected to do better in the future. Which might result in lower tax bills now and higher gains in the future. Just another opportunity to adjust portfolios.

I close with one more link that presents the story of a couple and their factors that helped them to decide to do a Roth conversion at Kiplinger titled Switching to a Roth Makes Sense Now
Pay Uncle Sam upfront and get tax-free income in retirement.
I hope you find the story interesting and as germination of some ideas.







Misc. Links {RSY V}:
The Dividend Play for a Lifetime (BWLD, CMG, FTR, MCD, NLY, PG, YUM)

Dividends Are Back - Investing - Stocks - SmartMoney.com

Are You Missing Out on Dividends? (IBM, KMB, KO, PCG, PG, PSA, SBUX)

Going down with the ship Commentary: Investment business is losing a generation of investors

Is This Really the Best Dividend Stock?

Strategies - Head for the Hills? No Way, Says Jeremy J. Siegel - NYTimes.com

Dividend Report Card: Coca-Cola (KO)

Think Twice Before Diving for Dividends (WY)

Dividend Report Card: Microsoft

Roth Conversions:
Is a Roth IRA Safe From Taxes? - MarketWatch
Duplicate: Is a Roth IRA Safe From Taxes? - Personal Finance - Taxes - SmartMoney.com

Portfolio rebalancing: How to do it right New study finds that using a time and target strategy may work best

Fidelty-Convert to a Roth IRA Factors to weigh when considering a Roth IRA conversion

Roth IRA Conversion - T. Rowe Price

Should I Convert To A Roth IRA? - Financial Calculators from CalcXML

Switching to a Roth Makes Sense Now Pay Uncle Sam upfront and get tax-free income in retirement.

7 Things To Know About The 2010 Roth IRA Conversion Rules

Switching to a Roth Makes Sense Now Pay Uncle Sam upfront and get tax-free income in retirement.

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