Converting to a Roth? Give to charity, too
Depending on your situation, it may make sense to convert funds in a traditional IRA into a Roth IRA this year, with the promise of future tax-free payouts. But you might have a problem paying the current tax due on the conversion.
Fortunately, there’s a way to offset the tax liability without reaching into your wallet.
Strategy: Make a sizable donation of appreciated property to charity. Generally, you can deduct the full fair market value of the property on this year’s return if you’ve owned it for more than one year.
In this case, the charitable deduction may reduce the Roth conversion tax bill or eliminate it completely.
Here’s the whole story: As opposed to a traditional IRA, contributions to a Roth IRA are never tax deductible, but qualified distributions from a Roth in existence at least five years are 100% tax-free. Qualified distributions include those made after reaching age 59½, on account of death or disability or to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). In contrast, distributions from a traditional IRA are taxed at ordinary income rates which can be as high as 39.6%.
Furthermore, you don’t have to take required minimum distributions (RMDs) from a Roth during your lifetime. With a traditional IRA, you must begin taking RMDs after age 70½. Therefore, you can preserve the Roth nest egg for as long as you want.
The trade-off is that you must pay tax at ordinary income rates in the year of the conversion. For 2014, the top tax rate is 39.6%. In addition, the conversion increases your modified adjusted gross income (MAGI) for other tax purposes.
Case in point: Under a recent tax law change, an additional 3.8% Medicare surtax applies to the lesser of your net investment income (NII) or MAGI above $200,000 for single filers and $250,000 for joint filers.
To reduce the tax, think “outside the box.”
Example: Assume that you’re a joint filer with a total taxable income of $250,000, including $50,000 of NII. This puts you in the 33% tax bracket in 2014. You want to convert $150,000 in traditional IRA funds to a Roth this year, but you don’t want the tax payments to erode the amount you’re transferring to the Roth.
In addition, you own stock you acquired five years ago for $50,000 that is currently worth double that amount, or $100,000. It’s been on your mind to donate the stock, plus some additional cash, to your alma mater.
If you simply transfer the IRA funds to a Roth IRA, you’ll owe a tax of $49,500 on the conversion (33% of $150,000). To compound your tax problems, you’ll owe a Medicare surtax of $1,900 (3.8% of $50,000). This will cost you a total of $51,400 in tax ($49,500 + $1,900) that comes right out of your pocket.
Better approach: Arrange to give the stock and $50,000 in cash to the school this year, allowing you to claim an extra charitable deduction of $150,000. The charitable contributions completely offset the income tax liability on the Roth conversion. You will still have to pay the Medicare surtax, because itemized deductions for charitable contributions don’t reduce your MAGI. However, owing an extra $1,900 is much better than owing an extra $51,400.
Note that other tax law limits may come into play. Significantly, the maximum amount you can deduct annually for a charitable contribution of property is limited to 30% of your AGI. Any excess is carried over to the next year.
Tip: A Roth conversion doesn’t have to be all-or-nothing. You can stagger conversions over several years.