The dilemma could not be better stated than by William Shakespeare in 1600: To convert or not to convert, that is the question.

It is difficult to find good advice on this subject because the two advisors who should best be able to help you decide both have conflicts of interest: CPAs and Investment Advisors. Most investment advisors get paid a percentage of assets under management, so if you send the IRS any material amount (withdrawn from your investment accounts), you may be reducing your investment advisor's income. And most CPAs, while they don’t technically have a conflict of interest, are so invested in the notion that “you never accelerate income taxes” that they just can’t see the error of their own advice in the face of arithmetic that paints a different picture.

At the end of the day, it is all arithmetic: Are you better off financially if you convert or don’t convert? Stated another way, will you or your family end up with more spendable wealth with or without conversion? The answer is not an easy or satisfying answer: It depends.


THE BASICS

Just to make certain we are all on the same page starting out, the idea of the Roth conversion is that owners of traditional IRAs pay income tax at their current rate on all IRA funds they wish to convert to a Roth IRA. What they get in return is (a) no income tax ever on any amounts they withdraw, and (b) they no longer have required minimum distributions. Roth IRAs can be inherited by children and even grandchildren.
Smart folks will recognize intuitively that whether or not to convert depends on (a) how much it will cost to convert, (b) how long the money will have to compound, (c) the rate of return earned by the funds invested, and (d) the tax rates that will apply to funds when withdrawn from the traditional IRA if they don’t convert. None of those variables are certain.


SOME IMPORTANT ROTH MECHANICS

Before we get to the "Do I or don’t I?" analysis, let’s focus on some important mechanics and options.

If you do convert, you can choose to pay all the taxes in the year of conversion. So if you convert today, you can pay all the taxes at 2010 rates by April 15 of 2011. Or you can pay half the taxes at 2010 rates in 2011 and half at 2011 rates in 2012. No one knows what those rates will be, but it is pretty safe to say they will be higher than 2009.

Many readers will have known this. What you may not know however, is that if it doesn’t work out, or if April 15, 2011 rolls around and you don’t have the cash to pay the tax, you get a “do-over”, more properly termed the right to re-characterize the newly-created Roth back to a traditional IRA, without any cost or penalty. In fact, you can re-characterize all the way to October 15, 2011.

So other than some extra paperwork for your investment advisor’s assistant, there is no reason not to create a Roth if you think there is a possibility that April or October 15 will have rolled around and you might wish that you had converted. You don’t want the ship to have sailed and you missed it, when you can purchase a fully-refundable ticket.


WHEN YOU SHOULD DEFINITELY NOT CONVERT

In the following circumstances, you may as well forget about Roth conversion:

(a) You do not have, and will not have, the ability to pay the income tax on amounts converted … or doing so will materially interfere with lifestyle needs.

(b) You have less than 7 years, and probably less than 10 or 12 years, for the funds to grow and compound.

(c) A subset of (b) above, you have a life expectancy of 5 or 10 years and you intend to leave it to children, for whom it could compound tax-free another 20 years or more, but you know in your heart of hearts that your children will spend it rather than allow it to continue compounding inside the Roth.

(d) You think the government cannot be trusted and that Congress will renege on its promise that converted Roths will forever be income tax free.


WHEN YOU SHOULD SERIOUSLY ANALYZE THE ARITHMETIC OF CONVERSION

In the following circumstances, you should seriously consider conversion and have your advisors run the numbers on a variety of “what-if” scenarios.

(a) You don’t need your IRA funds and wish they didn’t have Required Minimum Distributions after age 70-1/2.

(b) You have plenty of liquidity, that you won’t need, to pay the taxes created by conversion, say about 40% of the total amount converted.

(c) You are sure the money will be able to “ride” long enough, say at least 12 but perhaps 15 to 20 years, for the earnings to overcome the up-front income taxes.

(d) You wish to leave the Roth IRA to grandchildren, where it can be exempt from both generation-skipping transfer tax (GST) and income taxes until the grandchildren receive it, perhaps 20 to 40 years.


HEDGING YOUR BETS

Roth conversions are not an “all or nothing” proposition. You can convert some, but not all. You can convert all, but re-characterize only some. Or you can get even more clever than that.

Some of the more sophisticated thinkers on this subject, such as Bob Keebler, one of the leading IRA experts in the country, recommend that you divide your current IRA into 2 or more, each containing different asset classes. For sake of this example, let’s say you were to place all your equities into one traditional IRA and all your fixed income investments into another. Then you convert each traditional IRA to a Roth. When April, 2011 comes around, you may determine, based on what has happened in the financial marketplace in the year since conversion, that you wish to keep your “equity” Roth IRA and re-characterize your “fixed income” IRA, or vice versa.


DON’T DO ANY OF THIS WITHOUT A GOOD TEAM

We believe so strongly in the benefits of multidisciplinary team planning that our firm will not accept clients who do not have—or are unwilling to assemble—a team of competent advisors including accountant, investment advisor, insurance professional and estate planning/tax lawyer. There are a number of moving parts to manage in a Roth conversion, including the financial analysis and the dates for paying taxes and re-characterizing back to a traditional IRA.

If this sounds like a lot of work, it is, but mostly for your advisors who should embrace the challenge of helping you determine whether Roth conversion is a good idea for you and your family.