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Bob Keebler on Refining the Roth Strategy

In this audio stream, Bob Keebler covers the new thinking as it relates to Roth planning given market volatility. Key considerations include:

  • Opportunistic conversions (i.e., optimizing Roth segregation strategies, which focus on the volatility of the stock market)
  • Hedging against increased tax rates
  • Tactical planning (i.e., net operating losses)
  • The annual Roth conversion strategy

Important to note is that conversions to Roth 401(k)s cannot be recharacterized.

Bob Keebler on Refining the Roth Strategy - 12/9/2011

If you prefer, you can read the entire transcript after the jump or download this and other audio webcasts from the Personal Financial Planning Section on AICPA.org.

Robert S. Keebler, CPA, MST, DEP, Partner, Keebler & Associates, LLP. Bob is a 2007 recipient of the prestigious Distinguished Estate Planners award from the National Association of Estate Planning counsels. From 2003 to 2006, Bob was named by CPA Magazine as one of the top 100 most influential practitioners in the United States. He is the past Editor-in-Chief of CCH's magazine, Journal of Retirement Planning and a member of CCH's Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration.  

This audio webcast was originally recorded Dec. 9, 2011.

Transcript: 

On behalf of the AICPA's Personal Financial Planning Division, this is Bob Keebler to discuss Roth conversions in 2010, making a case for converting to the Roth.

After 14 years of counseling clients on Roth conversions, the knowledge of who should and who should not convert is continuing to evolve.  The first ten years, most of our collective efforts focused on the long-term strategic benefits of a Roth conversion, kind of a CPA's paradise, with tax professionals going behind a mythical curtain to analyze the labyrinth of tax law and complex mathematical relationships.  That was then, this is now.

Over the years, investment experts and finance professors have added to the knowledge base by contributing insight on asset allocation between Roth and traditional IRAs, and by refining the Roth conversion strategy, the Roth conversion strategy being one of three reasons to convert to the Roth IRA, namely tactical reasons, like your client has a large tax attribute that was sheltered dollars, or is in a low tax bracket or has plenty of basis; strategic reasons, like the ones we focused on for the five years, by crunching numbers and seeing if you came out better; or opportunistic reasons is where the Roth segregation strategy lies, where you convert, hoping to take advantage of the volatility of the stock market.  A fourth reason we've been looking at conversions recently is when clients own interests, minority interests in partnerships.  Very often, when we convert, the test is going to be willing buyer, willing seller.

So, four things:  Strategic conversions, those are the long-term conversions that are mathematically driven; tactical conversions, which are conversions largely driven by looking at a person's tax return and finding a tax attribute; and finally, opportunistic conversions, which basically focus on the volatility of the stock market.  And after that, you can add maybe a fourth category of taking advantage of minority interest discounts in the context of minority interests in limited partnerships, corporations, property like that.

So over the years, everything's evolved, and by now, many sophisticated CPAs have developed a firm perspective on who should and who should not convert to Roth.  Recently with the volatility of the stock market, we've come to challenge some of that, and we've put the best minds in the profession together, and they've changed their focus.  Nearly 100% of the knowledge we've developed in the last 24 months collectively across the finance, legal and accounting professions have focused on opportunistic conversions and the finance of this.

This new knowledge has focused on recharacterizing IRAs.  This knowledge, coupled with the high likelihood of increased tax rates and continued wild swings in the market, has caused us to reassess our complete approach to Roth conversions.  In the past, all of us would retreat to the comfort of a quiet corner of our office and run endless numbers to support our conclusions.  And while this is very important and we shouldn't ignore the fact that we have to crunch the numbers, most of the number-crunching now should be done right before you recharacterize rather than on the day you convert, because crunching the numbers on the day you convert is largely a waste of time, because you're going to want to see how everything evolves.  You're going to want to see whether these accounts have gone up in value, and you should consider keeping them in the Roth IRA or whether these accounts have gone down in value and you automatically are going to recharacterize.

So I firmly believe our focus must be, our energy must be on the new ideas, including optimizing the segregation strategy, hedging against increased tax rates, the annual Roth conversion strategy, which I'll explain in a moment, and tactical planning like NOLs.

Now, if a client converts in early 2012, the question is people might be coming to you right now, and they're going to say, "Should I convert in 2011 and 2012?"  Absent a very tactical reason rate-wise, NOL-wise, charitable carry-forward wise, minimum tax credit-wise, you are going to want to convert in 2012, not 2011.  And the reason for that is simple:  If you convert on December 20th, 2011, you are only going to have until October 15th, 2012, to recharacterize, roughly ten months.  However, if you convert on January 3rd, 2012, you're going to have up until October 15th, 2013, which is basically 21 and a half months, a very long period of time.

Now, when I was trying to prove that out, I looked at the options going forward, like if you were to buy a call option.  And the premium through September of 2012, which is kind of when all these decisions would be made, is roughly -- on the SPY, S-P-Y -- is roughly 9.5%.  But if you jump out further, you're more in the 13% range.  Now, the moral of the story is, option theory and -- you know, and the whole finance behind all this volatility says the longer your time frame to make a decision on recharacterization, the greater the probability that the market will have gone up in value.  Now, it's likewise, the greater the probability the market will have gone down in value.

So what we want to do is we want to focus in on the Roth conversion strategy by asset class.  Okay?  We want to focus in by asset class, and then we want to build in as much time as possible.  Now, remember -- I'm going to go very slow here, because this is critical; write this down, please -- no recharacterizations of 401(k) to Roth 401(k) conversions.  If a person converts $500,000 in their 401(k) plan to a Roth 401(k) and the market falls by 50%, they have just destroyed their 401(k), because they're still going to owe tax on 500,000 -- call it $200,000 -- but their account is only going to be worth $250,000.  It's a disaster.

So when you're working on -- I would avoid, unless it's a bond portfolio, I would avoid large conversions from 401(k) plans to Roth 401(k) plans unless you can hedge that somehow with outside options, or you can alternatively look at maybe doing that conversion over eight quarters.  In other words, if it was 500,000, you divide by eight, and you would convert one-eighth on January 1st, one-eighth on April 1st, and so on, trying to smooth out any of that risk.

So basically, the Roth conversion segregation strategy is where everyone's going to start, and that gives you a tremendous privilege of recharacterizing from the Roth IRA back into a brand-new regular IRA.  So that is important.  And the reconversion strategy goes something like this:  For the accounts that have gone up in value, I will keep those in the Roth.  For the accounts that have gone down in value, I'll recharacterize those.  And then, let's say it went from 100,000 down to 85,000, I would recharacterize.  But then 30 days later, or January 1st of the following year -- and I'll talk about that in a moment -- you're going to jump back into the Roth IRA.  But your entry point is going to be lower.  This is a very, very important thing.  I'm worried more about volatility than I am against -- about rates.  Now, that's the reconversion strategy.

We also want to talk about hedging against increased tax rates.  If tax rates increase, you retain the Roth IRA.  So if you converted to the Roth and tax rates increase, perhaps you retain the Roth IRA.  And if rates do not change, you exercise your privilege to recharacterize.  This provides a truly unique, no-risk opportunity.  In all likelihood, my own thought, watching Congress for many years, talking to some really smart people that are on the Hill that -- everyone's kind of resolving themselves that we're probably going to go back to President Clinton's tax rates on January 1st, 2013.  Now, what that means is that for most of your clients they're going to go from 33 to 36 or from 35 to 39.6, as far as rates.

Now, if you're in the health care surtax and you're into what we call the surtax bubble, although the IRA distributions themselves are not subject to the surtax, what's going to happen is if the IRA distribution when you turn 70 pushes your income up over 250,000, you're going to be in the surtax bubble.  And reality is that you're more likely -- in that instance, you're going to be in a 43.4% federal rate.  Okay?

Now, the other thing that comes in here, although no one is giving it much likelihood of passing.  We do not know what the voters are going to do in November, and if somehow the Democrats retook the house, which seems unlikely, but you never know, we'll end up with a millionaire surtax.  And that's something that you have to watch, because if that's happening, large Roth conversions, like many of the ones I've been involved with, are going to be over, or at least severely dented if you add a two-point millionaire surtax to that and if rates jump from 35 to 39.6.  So you're looking at a potential arbitrage of anywhere from 4.6%, 39.6 minus 35, to roughly 10.4% if that 2% millionaire surtax were to come into the law.  So we don't know exactly what's going to happen, but we know tax rates are likely to go up.  But if we're wrong, we can recharacterize.

And so even if a person invested 100% in bonds or CDs and they were unable to take advantage of the volatility of the market, hedging against tax rates still creates a heads you win and ties you tail -- and tails you tie situation, okay?  So that's really what we're focused on.

Now, let's look at the other ideas we have.  The other idea out here is what is the effect of a conversion recharacterization on RMD?  So I want you to picture this.  You have a client age 74 years old, and he or she converts to the Roth and then they recharacterize.  So there's an interesting anomaly in the Roth regulations that is going to be helpful to clients past their required beginning date.  This is very complex, so hang on for a little bit of a bumpy discussion here, but we'll go through this.

Now, first of all, this is not just my opinion.  This is something that a number of other people have been on discussions on, and I believe this is the conclusion of the group of how this works.  Although I was involved in the discussion, I was hardly the leader.

Now, what we have to understand is that before you convert to a Roth you have to take out your RMD for that particular year.  Now, once you've done that, then you -- once you're in the Roth, you're no longer required to take minimum distributions.  We know that.  The required minimum distributions for a regular IRA must occur by December 31st, and converting it to the Roth during a particular year will not reduce the RMD for that specific year.  In fact, the RMD must be taken before you can do a Roth conversion.

Now, the only exception to that is a case I have right now with a professor who has $3.2 million in his 403(b) plan.  He's 79 years old, he's still working, and at the end of the day he does not have to take RMDs, which I found very interesting when we looked at this in depth.

Now, let's look at an example.  A taxpayer age 74 took an RMD for 2011 and converted to a Roth immediately.  If he did that, no 2012 RMD is going to be required.  The interesting issue is what happens if they later recharacterize back into a traditional IRA.  Now, let's go through this example.

Herman, age 74, converts $500,000 from a regular IRA to a Roth, and he just has a CD in that account.  Now, this is 100% of all his IRAs.  Later he recharacterizes when the value is exactly 500,000.  His 2012 RMD base must include the 500,000.  This is fair, and the regulations properly reflect the economic reality.  So you go back and you take an RMD based on 500,000.  That's very, very easy.

Now, let's say Herman's IRA had jumped from $500,000, and he recharacterizes when the value's exactly 600,000.  His 2012 RMD base must include the 600,000.  Even though he converted 500, you have to include the new value.  In essence, he gets hurt.  This is unfair, and the regulations should place the taxpayer in the exact same position as if he hadn't converted in the first place.

This example, however, is somewhat unrealistic, because if you were this client's CPA, you'd say, "Wait a minute, you went from 500 to 600.  Forget that recharacterization stuff.  We're going to leave the money in the Roth IRA."

Now, let's look at a different example.  Same client.  The 500,000 falls to 400,000.  His RMD base must include the 400,000, not the 500 he converted, but the 400, the value on the date of recharacterization.  Now, this, too, is unfair, and the regulation should have placed the client in the same economic situation with the RMD.

Now, I think the way we look at this as CPAs is a little bit different than what someone that wasn't trained as a CPA would -- how someone that wasn't trained as a CPA would look at it.  I think it comes down to probably a concept we learned in the first or second semester of accounting, kind of that matching principle which is burned into our brain, and that's why we say it should be 500.  But what the regs say is you use that new value of 400.

Now, what does this mean?  Let's put this in perspective, please.  What this means is, this is exactly where the opportunity lies.  If Herman was able to remove 100,000 from his base, his RMD is going to decrease, say, by 5 or $10,000.  So he can create a complete heads you win, tails you tie scenario.  If the account goes up in value, you leave it in the Roth.  If the account goes down in value, you recharacterize, but your RMD is lower.  This is a great deal.

Now, to make this even better, remember you've converted by asset class.  Say you've done ten conversions.  Some are going to have gone up and some are going to have come down.  So Herman creates, from a tax perspective, a gain at -- you know, a heads you win, tails you tie situation -- or a heads you win, tails you win situation.  No matter what happens, he is going to be better off.  And that is -- There's going to be a gain associated with that.

Now, keep in mind, what you're hedging against is tax rates could increase.  You're hedging against that his wife could die in the meantime, and single rates are greater than married rates, and he may survive his wife five to ten years.  I think that's going to be my situation with this professor, is that his wife already passed away, and at the end of the day, you know, we're in the situation here where he wants to convert before he's in those higher rates.

Now, basically, the tax rate on the conversion, how do you figure out the tax rate?  Now, let's look at this very easily.  Let's say you're in the basically 25% rate and you convert 100,000.  All of us would say that rate is 25%.  But let's say now that that value has gone up to 125,000.  Your taxes are still 25.  That rate is realistically a 20% rate, not a 25% rate.  Now, the big issue becomes, what do you do after a successful Roth conversion?  How do you reallocate your account between stocks and bonds?  And we'll talk about that in a different podcast.

A couple of other things we want to focus on.  One is -- I mentioned this at the beginning, but do not forget about tactical conversions.  Look at a client's tax return.  Look for things like basis, NOL carryovers, tax credit carryforwards.  Look for minimum tax credit carryforwards, charitable carryforwards.  Are there attributes in that tax return that will bring down the effective rate when you do a Roth conversion?

Now, finally, one final thought.  One strategy we've been using with many clients, we call it the annual distribution Roth conversion strategy, and here's how it works:  Basically, what you do, on January 1st, 2012, you've got a client that wanted to take out $10,000 a month.  They could either take it out of their regular IRA, and in the meantime, when it's earning interest, all of that growth would be taxable, and on their tax return you'd put $120,000 of an IRA distribution, period.

Now, if you converted the $120,000 to the Roth IRA on January 1st, 2012, then you took out $10,000 a month from the Roth IRA, all the interest you earned in 2012 would be on the Roth side of the equation, not on the regular IRA side of the equation.  Now, over one year that may not make a big difference, but over a period of ten or 20 years, that's going to be a big difference in how much wealth is going to be transferred.

This is also an extremely powerful idea for individuals that have very, very large IRAs, and they're looking at maybe a 3 or 4 or $500,000 annual distribution.  Making that work is going to be a very powerful thing.

So we've covered a lot of ground today.  Hopefully I've given you at least one or two jewels of information.  In closing, we want to thank you for being here today, and we also want to remind you, to keep up with the latest news and resources to help you navigate issues such as these in your practice, be sure to read the AICPA PFP News, which is delivered to PFP Section members weekly via e-mail.  For regular updates on legislative and regulatory issues, you also may want to visit AICPA.org/PFP/advocacy.  Again, this has been Bob Keebler for the AICPA, and thank you for joining us today.

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