Posted March 1st, 2010

Making the Conversion to a Roth IRA Less Taxing

Like a traditional IRA, a Roth IRA allows funds to be invested and reinvested on a tax-free basis. A Roth IRA, however, also allows for tax-free withdrawals, a feature which holds wide appeal. In the past, only those with a modified adjusted gross income of less than $100,000 have been eligible to take advantage of the Roth IRA alternative.

Beginning in 2010, taxpayers with higher incomes may now contribute to a Roth IRA and convert a traditional IRA to a Roth IRA. The potential market for this new opportunity is substantial. According to retirement plan specialists, some 13 million higher-income individuals currently hold $1.4 trillion in traditional IRAs, and millions of others may also benefit from a Roth conversion.

Pros and cons

The potential advantages to a Roth IRA include continued tax-free growth of investments, tax-free withdrawals, no minimum required distribution, and the opportunity for heirs to inherit a Roth IRA without having to pay the income taxes they would owe when inheriting traditional IRAs.

The biggest disadvantage associated with a Roth IRA conversion is the fact that income tax must be paid on amounts as they are contributed or on pre-tax contributions and other increases in account value when a traditional IRA is converted to a Roth IRA. In 2010 only, a taxpayer may opt to pay all of these “conversion taxes” in 2010 or may decide report the income in equal amounts in 2011 and 2012.

As is normally the case with financial decisions of this sort, individuals should carefully weigh their options and consult with appropriate advisors before deciding whether to convert a traditional IRA to a Roth IRA and determining when to report the taxable income that results from a conversion.

Minimizing the tax impact

As is the case whenever reporting income for tax purposes, there can be a variety of ways to offset or reduce the amount of tax due. The income from a Roth conversion is no exception. Tax credits, losses, charitable gifts, other deductions, or carryforwards can serve to reduce or eliminate the tax bite due to the conversion. Deductions can offset the Roth conversion income on a dollar-for-dollar basis up to the maximum allowed for income tax purposes.

For this reason, charitable gifts can be an especially flexible tool that can help minimize taxes that would otherwise be due, while at the same time fulfilling one’s charitable goals. Let’s examine a number of options that might be useful in this regard.

A plan in action

John, a successful 35-year-old professional, has a traditional IRA he has been funding over his working career. He has considered converting this IRA to a Roth IRA but is concerned about conversion taxes. The account currently is valued at just under $25,000. John also has been considering a five-year pledge totaling $25,000 to a capital campaign. Instead of spreading out his commitment over five years, he decides instead to fulfill the entire pledge in 2010. As a result, he is able to completely offset the taxes associated with his Roth IRA conversion. To maximize his savings, John decides that instead of using cash to make his gift, he will give stock that is now worth 50% more than he paid for it just a little over a year ago. In so doing he completes his gift, owes no tax on the conversion to a Roth IRA, and bypasses capital gains tax that would otherwise be due if he had sold the stock.

Cindy has given very generously in the past and has $100,000 in “carryforwards” for charitable deductions that she has been unable to use in the past due to percentage of AGI limitations. After talking to her advisors she decides to make a Roth IRA conversion and use the charitable deduction carryforwards to eliminate the tax on the conversion. Not only will she owe no tax on the conversion, but she will also no longer have the carryforwards that have been impeding her ability to make additional tax-deductible contributions.

Mr. & Mrs. Davis are well off financially and have a substantial traditional IRA they would like to convert to a Roth IRA. They have also planned to make a large bequest to a favorite charity. In addition to their main residence, they own a lake house worth more than the balance in the IRA. Their advisors suggest that in lieu of a bequest, they should deed the remainder interest in the lake house to the charity while they retain the full use of the property for their lives. The arrangement, known as a “qualified life estate,” generates a charitable deduction that will be large enough to offset the conversion tax that would otherwise have been due when they filed their 2010 tax return.

Marcy has decided to convert her traditional IRA to a Roth IRA. To offset the income tax that would be due on the conversion, she has decided to use cash to fund a deferred gift annuity that will supplement her other retirement income. She is working with her accountant to determine if it would be better to report the transaction in 2010 or to break it down over 2011 and 2012 and fund additional deferred gift annuities in those years.

The Smiths, a wealthy couple, have been considering establishing a charitable remainder unitrust. Their financial advisor points out that if they fund the remainder trust this year they would largely eliminate income taxes that otherwise would be due after converting a traditional IRA to a Roth IRA. To maximize their tax savings, they decide to fund the trust with appreciated, low-yielding securities, thereby bypassing capital gains tax at the time the trust is funded. They also select a relatively low payout that results in an increased charitable deduction. In this way, they will offset as much of the conversion tax as possible while allowing more room for the CRT to grow over time. They decide to leave the tax-advantaged Roth IRA to their children so they will receive the funds free of income tax rather than having to pay the tax that would have been owed on a traditional IRA.

These are just a few of the situations in which charitable gifts may be made in ways to make the conversion of a traditional IRA to a Roth IRA less taxing. While the basic concept is relatively simple, the details can be more complex. As noted above, a donor who is considering a Roth conversion should work closely with tax and financial advisors for advice that is tailored to his or her situation.

Note: The Sharpe Group has prepared a multi-channel marketing bundle to help you communicate the benefits of thoughtful planning to your constituents. See page 5 for details.

The publisher of Give & Take is not engaged in rendering legal or tax advisory service. For advice and assistance in specific cases, the services of your own counsel should be obtained. Articles in Give & Take may generally be reprinted for distribution to board members and staff of nonprofit institutions and other non-donor groups. Proper credit must be given. Call for details.

Give & Take

Site Search

Give & Take Archives

2017 Issues 2016 Issues 2015 Issues 2014 Issues 2013 Issues 2012 Issues 2011 Issues 2010 Issues 2009 Issues 2008 Issues 2007 Issues 2006 Issues 2005 Issues 2004 Issues 2003 Issues 2002 Issues 2001 Issues 2000 Issues 1999 Issues 1998 Issues 1997 Issues