In 2010 thousands of retirees will get conned by misinformed or unscrupulous salespeople who will talk them into an unsuitable Roth IRA conversion. If you want to become one of those people who, like Bernie Madoff, make themselves rich at the expense of their unsuspecting clients, here is a step-by-step guide:
1) Use a Roth IRA Conversion calculator similar to the one offered by CalcXML. This calculator is perfect, because it leaves no trace; your name does not appear, nor does the name of your client. Throw away the second page to avoid embarrassing questions about your input.
2) Use a lower tax bracket in the pre-retirement, “accumulation” years than the post-retirement, “distribution” years. This printout uses 25% and 33%.
3) Since this client does not have $250,000 of ready cash to pay the taxes for the conversion, use “Option 2,” where the taxes are painlessly paid from the existing IRA funds.
4) Sell a product that has a 25% premium bonus and explain that the bonus will cover the income taxes.
Informed financial professionals can instantly see problems with the above scenario:
1) Ethical financial professionals never use calculators that omit their contact information, the client’s name, assumptions used, pertinent disclosures, and includes a sentence about seeking the advice of an income tax professional.
2) A Roth IRA Conversion calculator that uses “Tax Bracket” fields can be manipulated to deceive the client as I did in the sample printout. As a minimum it should have an input for “Adjusted Gross Income” and use the income tax rates that President Obama proposed for 2010 and beyond. Nobody who has $500,000 added to their income in a single year is in a 25% tax bracket!
3) The software should take all income tax ramifications into account. The sample printout does not take into account the fact that the client is age 56, and would incur an additional $25,000 tax penalty (10% early withdrawal penalty).
4) Taking into account both of above mentioned potential tax issues, the income tax impact for this client is about $250,000 higher than what was disclosed!
5) Products with premium bonuses may help offset current income taxes, however, a premium bonus is never “free.” There is always a cost somewhere, often in the form of lower interest rates.
I recommend the following safeguards to protect consumers from tax penalties and financial institutions and their representatives from potential lawsuits:
1) Insurance companies, marketing organizations, and broker / dealers should train their representatives about a how a Roth IRA conversion will affect a client’s current and future income tax situation, and how to determine whether it is suitable for their client.
2) Insurance agents and registered representatives should insist that a licensed income tax professional review the tax calculations and assumptions of Roth IRA conversions over $100,000. This may save the client tens of thousands of dollars in taxes, and a tax professional’s endorsement may shield against a future lawsuit.
3) File a complaint with the appropriate supervising authority against any insurance agent or securities representative who uses the above unethical approach to Roth IRA conversions.
4) Financial institutions should review all calculations and reports, including the tax professional’s review, before implementing a Roth IRA conversion.