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Roth IRA Conversions, Part II: To Convert or Not, That is the Question…

By Jonathan Gudema Esq. on April 27, 2010No Comment

As a follow-up to my previous piece about the opening of Roth IRA conversions to higher income levels ($100,000+ AGIs) and the potential for increased charitable giving as a result, I thought it was important to review the thoughts and planning that Roth IRA converters should consider prior to taking advantage of this new opening in tax planning. Number one, you need to be fully informed of the consequences of adding more “ordinary income” to your adjusted gross income (AGI) – the result for all funds converted to a Roth. 

That is, you pay taxes on the amounts converted.  Let’s say between 25% and 35% for the federal income tax purposes and add another 5% to 7% depending on the state you live in. See the below table:

Federal Income Tax Brackets for 2010 (medium and higher AGIs)

Tax Bracket Single Married Filing Jointly
25% Bracket $34,000 – $82,400 $68,000 – $137,300
28% Bracket $82,400 – $171,850 $137,300 – $209,250
33% Bracket $171,850 – $373,650 $209,250 – $373,650
35% Bracket $373,650+ $373,650+

If you are typically in the 25% bracket and you convert $100,000 of traditional IRA funds into a Roth in 2010, then you will be adding $50,000 in each of those years in taxable income to your 2011 and 2012 AGIs.  Let’s do the math:  25% of $50,000 amounts to $12,500 in additional taxes you would need to pay each of these years to the Feds – assuming no planning is done to offset these taxes.  And, also assuming these are the tax brackets for those years, which – by the way – might be going up.

Expanding on this example, let’s say you are married and your AGI is around $125,000.  In 2011 and 2012, your AGI now reaches $175,000 each year because of the $100,000 Roth conversion you did in 2010, knocking you into the 28% bracket.  Not only are you now paying an additional $14,000 in federal tax in 2011 and 2012 on the Roth converted amounts spread out over each of those years, but you are being forced to pay an additional $3,750 each year on the income in your original AGI because you are now in a higher bracket.

Let’s add this up.  You will pay an extra $17,750 in federal taxes in both years for converting a $100,000 IRA into a Roth.  $35,500 in total, not including additional state taxes of around $7,000 over the two years.  Rounded total cost is around $42,000 to convert a $100,000 IRA into a Roth under this example.

What if a Roth conversion knocks you into the 33% bracket from the 28% tax bracket?  That is a 6% increase in taxes on your typical AGI earnings.  Off the top of my head, this might cost me (a 28% bracket guy being pushed into 33%) over $50,000 in total taxes to convert my $100,000 IRA to a Roth.

And, the payment of taxes does not come from the IRA funds themselves – they come from your pocket, other assets.

The purpose of this article is not to scare people away from Roth conversions.  Tax free compounded interest is an extremely powerful idea which individuals should try to find a palatable way to grab hold of.  The question though is: how to do with it without paying too much in taxes?

How to Minimize the Tax Bite in Your IRA Conversion?

Having practiced estate planning and charitable gift planning for some time, I learned something about estate planning and the payment of gift taxes by living individuals.  I noticed that lawyers, generally speaking, were only creating “zeroed out” lead trusts and GRATs (two sophisticated estate planning gambles).  By zeroed out, I mean that lawyers made sure that when using either of these asset transfer methods, they made sure that their clients pay little or no tax.  Both involve gifts to children, minus the value of an income interest either given to charity (lead trust) or paid back to the client (GRAT).   If you bend over backwards, you can inflate the value of the “income interest” to offset the gift to children.

The question I had was: why be so careful to avoid paying any gift taxes?  By zeroing out these trusts, attorneys were actually reducing the chances of the success of these estate planning vehicles.  Why not pay some gift tax and have a better chance of the trust succeeding by not burdening it with such a high payout (either back to the client or to charity) required to zero out a lead trust or GRAT?

What I realized is that since these gifting options were essentially gambles and the family at the end of the trust may have nothing, it didn’t make much sense to actually pay gift taxes on these plans.  Just keep them short and do it over again if it doesn’t work the first time, or second time, etc…  In other words, people are generally loathe to generational transfer taxes early – when you have little or no guarantee of the end results.

Same idea applies to Roth IRAs.  It is a gamble whether the dream of tax-free compounded interest will really work out for you.  In fact, you could lose the entire account in stock market volatility (a reason to be careful with these investments, by the way) and you would have paid a lot of money for this right.

No matter what the future benefits of having a Roth IRA may be, it would be hard for me to advise a client to pay a ton of taxes now when there is no guarantee that the funds will grow in the future.

So, do we ignore this opportunity?  Are there plans to offset the tax bite that work?

Offsetting the Roth Tax Bite with Charitable Giving

I am going to ignore all of the “schemey” plans out there claiming to help people avoid taxes on their Roth conversions.  If it is too complex to understand by your average person, my advice is to ignore it.

Charitable giving – plain and simple – offers the most obvious way for generous folks to take advantage of the Roth conversion option without paying extra taxes.

Back to our original $125,000 AGI example looking to convert $100,000 into a Roth IRA.  Very simple.  His new AGI in 2011 and 2012 will be $175,000.  The IRS lets one deduct up to 50% of your AGI with charitable gifts (30% of deductions against your AGI could come from appreciated stock – which avoids capital gains, too).  Plan on donating $50,000 each year (2011 and 2012) into a donor advised fund or for a capital campaign.  AGI gets brought back down to $125,000 each year.  No extra taxes owed – everything is back to normal.

Tax planning like this can be complex – too complex for this article – but safe to say, the person in this example will essentially be paying no additional taxes in either tax year due to his charitable giving.

And, now he has $100,000 sitting in a donor advised fund which he can use for years to come for charitable giving or he has a big naming opportunity in a capital campaign.

Now, you might say that with plan 1 (no charitable giving, just pay taxes) the only cost to our fictitious example is between $42,000 and $50,000 out of pocket; Plan 2 cost – gifting to charity to offset taxable income – our guy is out of pocket for $100,000.

But, let’s ask our guy a question.  Which option do you feel better about?  Paying $42,000 for the right for a potential windfall of tax free dollars for self or family sometime in the future?  Or, setting aside money for charity, while benefiting your family at no cost?

For those already charitably inclined, or becoming so inclined, the question is a no brainer.  It may just be a matter of how much do you feel you can afford to set aside for charity.  Or, maybe it is time to make an “ultimate” gift to your favorite institution.  Usually, bequests are individuals’ largest personal gifts to charity.  It could be time to give it now.  Name a wing or scholarship fund.  Do something big – that you might have normally left for your estate.

And, if you are not charitably inclined, and want to do a large Roth IRA conversion, good luck finding a clean way of offsetting the tax bite.  This whole Roth IRA conversion option is more like a Trojan horse for these types.  I am not sure it is worth it from a tax planning point of view to pay upfront taxes for this so-called tax-free dream – something about it just doesn’t sit well with me.  You have no real control over whether your Roth IRA investments will yield anything near the results your typical financial salesman will sell you.  In the end, you may be paying taxes now for little or nothing in the future.  Just something to think about before jumping into this.

Look out for Part 3 – Complex Charitable Trust Planning in Conjunction with Roth Conversions.

Jonathan Gudema, Esq. is a Managing Director in Planned Giving at Changing Our World, Inc., a philanthropic consulting firm advising nonprofits, philanthropists and foundations on effective strategies. Keep up with his blog at

http://theplannedgivingblog.wordpress.com/

He can be reached at jgudema@changingourworld.com

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