Roth conversion and charitable donations

By Nicole Gopoian Wirick, JD

Roth conversions are a hot topic given President Biden’s proposed tax reform and the possibility of higher tax rates. And for good reason, as prudent financial planning warrants an acceleration in income in lower tax years and a slowdown in income in higher tax years. This speed up / slow down strategy appeals to our rationality and a Roth conversion can be a great way to speed up income.

Nicole Wirick, CFP

In practice, however, I have found it difficult for most taxpayers to raise their hands to volunteer for a larger tax bill. In fact, this is enough to discourage many from a Roth conversion, although it might be in their best interests from both a personal financial and a legacy planning perspective.

With the much discussion about Roth conversions today, it is wise to examine potential changes in tax law, assess the potential impact from various tax considerations – not just ordinary income tax – and then consider a strategy that will work well with a Roth conversion better manage in taxes in the years of conversion and reduce or eliminate the dreaded check to Uncle Sam.

First, let’s review some of the components of the tax reform related to personal finance. Please note that Congress must pass these changes before they are implemented into law. The possibility of this happening is beyond the scope of this article as I am no policy expert and I simply cannot predict the future.

With that in mind, now is the time to start thinking about possible changes so that you don’t get caught on the wrong foot later in the year. Good planning takes time and cooperation with a qualified team of professionals.

Three tax considerations

Income Tax: The president announced plans to increase taxes for those with incomes over $ 400,000. The top tax bracket would increase from 37% to 39.6%. There is no clarity as to where the maximum tax rate would start and how the marginal tax margins between the maximum rate and $ 400,000 of income, if any, will be adjusted. This could create a sizable gap between the next higher marginal tax bracket of 32% and the new top tax bracket of 39.6%, adding to the need for good tax planning and opening up opportunities for both financial planners and clients.

Capital gains tax: Under the president’s proposal, capital gains for individuals with incomes greater than $ 1,000,000 would be taxed at the normal income tax rate. That means that capital gains tax would almost double for those affected by this change. Strategies to accelerate income and earnings gains in 2021 (assuming tax law goes into effect in 2022) can be of paramount importance to taxpayers in this category.

Inheritance tax: Although the President has not indicated whether to introduce a lower inheritance tax exemption (the amount you give tax-free on to your illegitimate heirs at the end of your life), he has expressed a desire to abolish the increase on a cost basis, with an exemption of $ 1,000,000 per person ($ 2,000,000 for a married couple) plus $ 250,000 for a primary residence ($ 500,000 for a married couple). This could have a dramatic impact on the way assets are passed on to the next generation.

Roth conversions can have benefits during the IRA owner’s lifetime that go well beyond those of reduced ordinary income tax by eliminating required minimum distributions (RMDs). A lower inheritance tax exemption, coupled with the ability to abolish the top-up cost base, could change the paradigm for identifying and transferring tax-optimized assets. Eliminating the increase in the cost base could make Roth conversions even more popular, as heirs receive tax-free growth and distributions from inherited Roth IRAs for ten years after the IRA owner dies. This is especially important when the IRA holder pays the tax from a taxable investment account, thereby reducing the taxable assets that could be subject to capital gains tax after the account holder’s death.

The downside is that IRA owners will have to pay ordinary income tax in the year or years they convert IRA assets to Roth assets. We have already indicated that careful planning will require accelerating earnings into lower tax years, which for those affected by the proposed tax reform will likely be 2021. But a Roth conversion is still a great opportunity for taxpayers in the lower marginal area. The tax cut under the Tax Cuts and Jobs Act expires in late 2025, and tax rates will rise for most taxpayers in 2026. This gives individuals with taxable income less than $ 400,000 an opportunity to accelerate income from 2021 to 2025.

Charitable purposes

After discussing this strategy with customers, the conversation is often very similar. Nobody wants to volunteer to pay taxes to Uncle Sam, but many want to support meaningful organizations, causes and communities in their lives. The decision often boils down to paying Uncle Sam or helping a charity. The conversation then turns to the offsetting of the normal income tax that is paid on the conversion, while helping these causes.

Those with charitable intentions might consider pairing a Roth conversion with a pooled charitable donation in a Donor Advised Fund (DAF) to offset the likely tax burden of a Roth conversion (or accelerated income). A transfer to a foundation advisory fund is tax deductible (additional tax savings if you transfer highly valued assets) and removes assets from the donor’s estate as the transfer is irrevocable. A DAF offers benefits through the three controls discussed above: Ordinary Income Tax, Capital Gains Tax, and Inheritance Tax.

Let’s look at an example: Mary gives the Alzheimer’s Association $ 20,000 annually because her mother was affected by the devastating disease. Rather than donating $ 20,000 annually, Mary decides to pool donations ($ 20,000 x 5 = $ 100,000) to a fund recommended by donors for five years. Once on the DAF, Mary can recommend grants to any qualified 501 (c) (3) organization in any manner appropriate to her. She has flexibility in distributing the funds for charity.

The advantages

First benefit – income tax: In the year in which she makes the donation, Mary can take over the entire deduction to the fund recommended by the donor, which is generally limited to 30% of the AGI for donations in kind (see the second benefit below).

If Mary’s AGI is not high enough to allow the full deduction, it will be carried forward for five years or until the full deduction is used, whichever comes first. When the DAF is paired with a Roth conversion, the Roth conversion increases revenue by the amount of the conversion. Bundling charitable donations over several years is likely to create a scenario where the taxpayer can list their deductions on their List A instead of taking the standard deduction.

Second benefit – capital gains tax: Let’s say Mary has low base stocks that she has held in her revocable escrow for several decades. If she bought the stock for $ 10 in 1980 and is worth $ 100 today, Mary would make $ 90 in capital gains by selling the stock and then writing a check to the Alzheimer’s Association.

If Mary donates the stock directly to DAF, she will receive the full $ 100 deduction and will not realize any capital gains. Assuming Mary is in the highest tax bracket, this will save her $ 18 in taxes ($ 100-10 = $ 90 x 20% LTCG Income Tax Rate) and give the Alzheimer’s Association the full 100 $ 82 after tax available versus $ 82. Mary gets a bigger deduction and the charity gets a bigger donation.

Under the plan proposed by the president, if Mary earns more than $ 1 million in annual income, her capital gains tax savings could nearly double. Note that the Medicare 3.8% surcharge is added in both figures but excluded for simplicity.

Third benefit – inheritance tax: Mary reduced the value of her estate by $ 100,000 as the transfer to DAF is irrevocable. Should the inheritance tax exemption be reduced as part of the presidential tax reform, a DAF provides a planning tool to extract assets from an individual’s estate. Assets outside the estate of an individual are not subject to estate exclusion or tax. The irrevocable nature of the gift also means that once it is in the DAF, Mary cannot withdraw it or use the money for non-charitable purposes.

As you can see, a Roth conversion and DAF pairing can be a fantastic strategy to offset higher income for those who prefer to support meaningful causes in their life rather than writing a check to Uncle Sam.

About the author: Nicole Gopoian Wirick, JD, CFP®

Nicole Gopoian Wirick, JD, CFP® is the Founder and President of Prosperity Wealth Strategies in Birmingham, Michigan. Nicole is a fee-based financial planner who believes that a successful advisory relationship requires compassionate discussions and planning security.

The information presented is for educational purposes only and does not intend to make an offer or solicitation to sell or buy any particular security, investment, or investment strategy. Investments involve risks and are not guaranteed unless otherwise stated. Make sure that you consult a qualified financial advisor and / or tax advisor first before embarking on any strategy described here. Past performance is not a guide to future performance.

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Email Jeffrey Levine, CPA / PFS, Chief Planning Officer at Buckingham Wealth Partners to: [email protected].