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By Barlow T. Mann
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.
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