Almost without fail, when financial advising and tax planning come up in the same conversation, a client’s Roth conversion is the first, second, and third examples advisors give. But, when should an advisor not recommend a client’s Roth conversion? In this article, we help advisors understand a few scenarios where recommending a Roth conversion to a client may not be an effective tax planning strategy!
Roth Conversion Conversation in the Advisor Industry
Many top advisors in the industry discuss the importance of Roth conversions. In fact, here are two great articles from Michael Kitces and Ed Slott to help advisors better understand Roth conversions.
Most professionals agree that a Roth conversion can be a great tool for reducing tax risk for a client. Furthermore, they can potentially reduce a client’s lifetime tax bill!
What is a Roth Conversion?
Roth conversions are a way to elect to pay the taxes deferred on a traditional IRA now. By doing so, they remove the future tax liability from that investment.
Typically, Roth conversions can reduce the client’s lifetime tax liability by doing the conversion in a year when the client’s tax bracket is lower than they expect it to be in the future.
If you want to learn more about Roth vs. traditional IRAs, then read this great article from Vanguard. This article explains when and how to do Roth conversions. It also covers the fundamentals of these important financial planning tools.
While Roth conversions can be a great way to add value through taxes to your clients, they are not a universally great idea. You need to take the time to understand your client’s specific situation before you propose this strategy.
7 Reasons Financial Advisors Should Not Recommend a Client’s Roth Conversion
First, advisors need to review the client’s most recent tax return, preferably the last two, to better understand a Roth conversion’s efficacy.
Without reviewing your client’s most recent tax returns, how can you be acting in the best interest of your client if you are proposing a tax strategy without understanding the potential impacts?
Through your ongoing relationship and CRM notes, you should be able to understand if any of the following reasons apply to your client’s situation. However, you will still want to have this talk with your client to ensure you are both on the same page. After all, they hired you to be able to explain complex issues and recommend potential solutions!
Now that you’ve reviewed their tax returns, here are 7 reasons NOT to recommend a Roth conversion to a client:
You and your client expect them to be in a lower tax bracket in the future.
Make sure you are considering one-time income increases as well as known income streams. The client might expect to have a lower annual income when they retire. But, if they want to take a large distribution to buy an RV or vacation home to enjoy in retirement, it could still make sense to slowly do Roth conversions over time instead of taking a six-figure taxable distribution in a single year.
Your client has no heirs other than charity.
You need to understand your client’s goals and what they are solving for with their tax strategy. For instance, if your clients plan to steadily draw from their retirement accounts to support their lifestyle and leave the excess to charity, a Roth conversion strategy may not be needed. This is a great reminder of the value of doing lifetime tax projections.
Your client despises paying taxes now.
Money is always emotional and for a lot of people, taxes are even more emotional. Don’t insult your clients by getting hung up on the objective tax savings if they are repeatedly telling you they want to delay paying taxes as long as possible.
Your client’s Roth conversion will significantly increase their adjusted gross income (line 11b of form 1040).
Many tax rules and requirements impact adjusted gross income. This is a huge reason it is irresponsible to recommend a Roth conversion (or other tax strategies) without reviewing the client’s tax return. You need to know whether the amount you are recommending is going to cause problems with the taxable portion of Social Security, Medicare premiums, or any other amounts tied to adjusted gross income. Although these may not be deal-breakers, it is important to understand if the client will come out ahead after the conversion.
Your client will be negatively impacted by the 5-Year Rules
Read the rules but more often than not they have been satisfied. This is because the clock does not start over with each conversion. But getting this wrong is a quick way to make your client, and their tax preparer, really mad!
Your client doesn’t understand what a Roth conversion is or why it’s right for them.
This is 100% on you as the advisor. If you have a strategy that will save your client taxes but can’t articulate it in a way they understand and are comfortable with, don’t do it! This should never be a “trust me, it’s going to help” approach. Your client doesn’t need to be an expert, but they need to be onboard.
Your client’s tax preparer is against the idea.
The only way you are going to know the answer to this one is if you ask. If you have reviewed the client’s tax return and proactively approach the CPA about the plan, that conversation is going to be quick and easy. However, if you make the decision without understanding all of the implications, you could potentially lose face with the CPA. Additionally, your client will be mad because they have unexpected taxes to pay and their CPA will be left to deliver the bad news.
Because You Are Not a CPA, Is Not An Excuse For Not Knowing How Roth Conversions Impact Your Client
Input from Matt and Micah from ThePerfectRIA
The advisors who leave all tax matters to tax preparers are missing an opportunity to deliver massive value to their clients. I speak to advisors who tell me they aren’t allowed to do tax planning, but they regularly help their clients with Roth conversions.
As an advisor, many of your recommendations and actions have tax implications for your client. Great advisors truly understand this and use it to deliver massive value to their clients. Furthermore, if your client works with a CPA or tax preparer, then this is a great opportunity to simultaneously build a new relationship with a Center of Influence.
Pro Tip: Before starting a Roth conversion, have your client discuss this proposed strategy with their tax preparer. Thus, proactively involving the tax preparer and distinguishing you from other advisors.
4 Action Items Financial Advisors Can Implement To Better Understand Roth Conversion Strategies
Here is what every great advisor should be doing related to Roth conversions:
- Get tax returns for every client every year.
- Use the 7 reasons above to identify which clients may or may not benefit from a Roth conversion.
- If a Roth conversion does not make sense, ensure you communicate the reasoning to your client. Also, document this discussion in your CRM. Highlight that although it does not make sense this year, you will continue to address it every year. This is the Dish Washer Rule – you only get credit for it if you mention it to your client!
- For clients who should consider a Roth conversion, add it to the agenda for your next meeting. Discuss and educate them on why it could be a good tax strategy. Make sure this gets documented in your CRM.
- Find a CPA you can partner with to review your overall approach to Roth conversions. Not many advisors do this. Therefore, it sets you apart in the eyes of the CPA who you would love to have referrals from AND almost guaranteed if you pick a good CPA there will be things you can learn from them to refine your approach.
Remember to tip your server, not the IRS!
