Tom Cooney of Arroyo Grande wants to convert his traditional IRA to one of the new Roth IRAs. He thinks.
Cooney, 65, has received conflicting information from his brokerage, his financial planner and his daily newspaper about whether such a conversion makes sense. “It’s confusing,” said Cooney.
So he has done nothing.
The complexity surrounding Roth IRAs--a new, nondeductible savings vehicle that’s tax-free in retirement--is one reason cited by banks, mutual funds and brokerages to explain why they’re seeing fewer conversions than they originally expected.
At discount brokerage Charles Schwab & Co., for example, fewer than 3% of 2 million existing IRA accounts have been converted to Roth IRAs, and most of those were in the first few months of 1998. At Wells Fargo & Co., fewer than 1% have been converted. Mutual fund giant Fidelity Investments reports that its conversions are closer to 10% but says investors still seem to be confused about when such a move would be advisable.
Most of the assets in IRA accounts are eligible for conversion. The Federal Reserve Board’s 1995 survey of consumer finances, the most recent data available, showed that 58.9% of IRA assets are held by households with adjusted gross incomes of less than $100,000--the limit for making the conversion. Adjusted gross income is income after 401(k) and other retirement plan deductions are taken but before exemptions and itemized or standard deductions. (AGI is entered at the end of the first page of a tax return.)
Some financial institutions still expect a last-minute rush of conversions as taxpayers take advantage of a one-time tax break that allows them to spread the income--and thus the tax bill--over four years, as long as they convert by Dec. 31.
Others say confusion, ignorance of the potential benefits and reluctance to pay taxes now will keep many potential converters on the sidelines.
“People that are really interested in converting are a small slice of the overall population,” said Richard D. Byrd, managing director of Wells’ private client group for Southern California. “A lot of people [who might benefit] just don’t want to learn about it.”
Roth conversions aren’t for everyone. But people who have seven years or more until retirement or who want to pass some of their IRA on to their heirs could be better off converting all or part of their nest egg. (See “Rolling, Rolling, Rolling,” C15.)
Whereas withdrawals from traditional IRAs are taxable in retirement, people older than 59 1/2 can withdraw Roth money tax- and penalty-free as long as they have held the account at least five years. A Roth conversion can mean tens of thousands more dollars to spend in retirement.
The Roth investor also has the option of not withdrawing money at all. Holders of traditional IRAs are required to begin draining the account once they have reached age 70 1/2, but Roths can be passed intact to heirs (minus estate taxes that might be due).
Wells is trying to goose customers into converting by offering free seminars explaining how conversions work and who might benefit from paying taxes now to avoid paying them in the future. Mutual funds and brokerages including Vanguard Group, Fidelity, T. Rowe Price and Merrill Lynch & Co. have showered their customers with newsletters, software and interactive Web sites to educate them about Roths.
The institutions say their efforts are basically educational, since conversions don’t add to their immediate profits. In the long run, however, the firms could wind up with more assets under management, especially since Roths have no minimum withdrawal requirements and the money could remain in their care for decades longer.
Financial institutions say educating investors about Roth benefits seems to work. Fidelity found in a survey of 506 IRA investors that the more people learned about Roths, the more likely they were to convert.
Recent changes by Congress also resolved some confusion and spurred conversions, said Susan Thompson, a spokeswoman for Merrill Lynch.
For example, Congress made it clear that people can undo a conversion if it turns out their adjusted gross income in 1998 is over $100,000, the limit for both singles and married people. Prior to the change, taxpayers had been warned that their IRAs could lose their tax-deferred status if a conversion was made in error.
The technical change briefly opened a loophole for taxpayers to repeatedly undo and redo their conversions to take advantage of the falling stock market in August and September, since a lower total value on their IRAs meant a lower tax bill on their conversions. The IRS stomped on that tax dodge last month, decreeing that taxpayers are now limited to redoing a conversion only once.
Until Congress passed the technical corrections bill, financial planners also advised their clients to keep Roth contributions and Roth conversions in separate accounts. Now the accounts can be combined, and the five-year holding period--which determines when certain types of tax-free and penalty-free withdrawals are allowed--starts in the year in which the first Roth contribution is made.
For tax purposes, withdrawals are first considered to be from Roth contributions, then from conversions, and, finally, from earnings on the contributed and converted amounts.
Being able to consolidate his accounts was a big issue for Cooney, who has a new contributory Roth, a small nondeductible traditional IRA started last year and a six-figure traditional IRA that was funded by a rollover of his 401(k) retirement savings from his job as a pharmacist.
Cooney’s financial planner convinced him it wouldn’t make sense to convert his large IRA, because Cooney needs to tap the funds to supplement his Social Security and $453 monthly pension. Even if Cooney doesn’t convert his large IRA, however, he wants to convert his $2,000 IRA and combine it with his existing $2,000 Roth account for record-keeping simplicity.
Figuring out his tax debt has also been difficult for Cooney. He understood from one mutual fund’s literature that if he converted the nondeductible IRA he started last year, he would owe taxes only on the earnings--since nondeductible contributions are generally subtracted from an IRA’s value to determine the tax bill. But taxes on withdrawals--conversions or otherwise--are figured by aggregating a taxpayer’s total IRA assets and using the proportion of nondeductible contributions to determine the taxable amount.
In other words, if an investor has $20,000 in all her IRAs and made a total of $4,000 in nondeductible contributions, one-fifth ($4,000 divided by $20,000) of any conversion she makes would be exempt from taxes. If she converted half of her IRA money to a Roth IRA, for example, she would owe taxes on $8,000.
Such details can be mind-numbingly complex for many investors. Some financial planners speculate that investors who may benefit from a conversion lack access to professional advisors who can answer their questions. On the other hand, people who do have professional advice often make too much money to qualify.
“Obviously, there’s more room for someone who is single to make a conversion, but you get two married people making $60,000 to $70,000 each, and the limit’s busted,” said David Flamer, a certified public accountant with Lasher, Flamer & Associates in Woodland Hills, who said most of his clients make too much money to qualify for a conversion.
But even those who can qualify, and understand the benefits, may balk at a conversion.
The Fidelity survey found that two-thirds of the investors polled already understood the main attraction of the Roth IRA--the fact that withdrawals are tax-free in many situations and free from taxes and penalties after age 59 1/2. About half that group was also aware of the Dec. 31 deadline for spreading out the tax bill.
What seems to be stopping most people is simply the idea of paying taxes now for a possible future benefit, Fidelity officials said.
“We’ve been so trained to defer taxes as long as you can” that the idea of taking the hit before you have to is anathema to many people, said Stephen W. Mitchell, the Fidelity official in charge of developing retirement products. “Are you really willing to [pay] money to reduce taxes in the future?”
Liz Pulliam can be reached by e-mail at firstname.lastname@example.org.
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Are Your a Candidate?
You may be a prime candidate to convert your traditional IRA into a Roth IRA if the first three points apply to you. The case for conversion is even stronger if either of the last two points applies. (See detailed pros and cons on C15. )
* Your adjusted gross income is less than $100,000, single or married.
* You don’t need to tap the money for at least five years.
* You have money outside the IRA available to pay taxes on a conversion.
* You expect to leave a large estate.
* You wouldn’t lose--or don’t care about losing--other deductions in the next four years due to conversion income.
Although the decision to convert an existing IRA into a Roth may not be easy, almost anyone eligible would benefit from opening a regular Roth IRA. As with a traditional IRA, you can contribute a maximum of $2,000 a year. Prime candidates:
* Your adjusted gross income is less than $95,000 (single) or $150,000 (joint). A reduced contribution can be made if incomes are less than $110,000 (single) or $160,000 (joint).
* You are already contributing enough in a 401(k) or other tax-deferred workplace plan to receive the maximum employer matching share.
Los Angeles Times