Roth conversion and charitable giving
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. This is for good reason since prudent financial planning justifies accelerating income in lower tax years and decelerating 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 accelerate revenue.
However, in practice, I have found that raising your hand to volunteer for a bigger tax bill is difficult for most taxpayers. In fact, this is enough to deter many people from converting to Roth, even though it might be in their best interests from both a personal finance and inheritance planning perspective.
Given the amount of conversation surrounding Roth conversions today, it is prudent to examine potential changes in tax law, identifying the possible impact through various tax lenses – not just income tax. ordinary – then consider a strategy that may well combine with a Roth conversion to better manage taxes in the year or years of conversion and reduce or eliminate the dreaded check to Uncle Sam.
First, let’s review some elements of tax reform as it relates to personal finance. Please note that Congress must adopt these changes before they are enacted. The possibility of this happening is beyond the scope of this article as I am not a political expert and simply cannot predict the future.
With that said, it’s time to start thinking about the potential changes now so you don’t get caught off guard later in the year. Good planning requires time and collaboration with a team of qualified professionals.
Three tax considerations
Income tax: The president has indicated his desire to increase taxes for people earning more than $ 400,000. The highest tax bracket would drop from 37% to 39.6%. It is unclear exactly where the top tax rate would start and how the marginal tax brackets between the top rate and $ 400,000 of income will be adjusted, if necessary. This could create a significant gap between the next top marginal tax bracket of 32% and the new top bracket of 39.6%, amplifying the need for good tax planning and creating opportunities for financial planners and managers. clients.
Capital gains tax: Under the president’s proposal, capital gains would be taxed at the regular tax rate for those earning more than $ 1,000,000 in income. This means that the capital gains tax would almost double for those affected by this change. Strategies to accelerate income and reap gains in 2021 (assuming tax law comes into effect in 2022) may be paramount for taxpayers in this category.
Inheritance tax: Although the President did not say whether a lower inheritance tax exemption (the amount that you transfer tax-free to your unmarried heirs at the end of your life) will be introduced, he did indicate that ‘he wanted to eliminate the mark-up. on a cost basis, providing an exemption of $ 1,000,000 per person ($ 2,000,000 for a married couple) plus $ 250,000 for a principal resident ($ 5,000,000 for a married couple). This could have a huge impact on how assets are transferred to the next generation.
Roth conversions can have benefits far beyond reducing ordinary income tax over the life of the IRA owner by eliminating the minimum required distributions (RMD). A lower inheritance tax exemption, coupled with the possibility of eliminating the mark-up from the cost base, could create a paradigm shift related to the identification and transfer of tax-optimized assets. Eliminating the increase in base costs could make Roth conversions even more popular since heirs will receive tax-free growth and distributions from inherited Roth IRAs for ten years after the death of the IRA owner. This is especially important if the owner of the IRA pays tax from a taxable investment account, thereby reducing the portion of taxable assets that could be subject to capital gains tax upon the death of the owner. Account.
The downside is that IRA owners will incur ordinary income tax in the year or years they convert IRA assets into Roth assets. We’ve already noted that careful planning dictates accelerating income in lower tax years, which could likely be 2021 for those affected by the proposed tax reform. But a Roth conversion also remains a great opportunity for taxpayers in the lower marginal brackets. The tax cut under the Tax Cuts and Jobs Act expires at the end of 2025, and tax rates will increase for most taxpayers in 2026. This provides the opportunity for those whose taxable income is less than $ 400,000 to accelerate their income from 2021 to 2025.
After discussing this strategy with clients, the conversation is often quite similar. No one wants to pay voluntary taxes to Uncle Sam, but many want to help important organizations, causes and communities in their lives. The decision often comes down to paying Uncle Sam or supporting a charity. The conversation then turns to offsetting the ordinary income tax paid on the conversion while helping these causes.
Those with charitable intentions might consider pairing a Roth conversion with a charitable donation pooled into a Donor Advised Fund (DAF) to offset the potential tax burden of a Roth conversion (or any accelerated income for that matter). . A transfer to a donor advised fund is tax deductible (tax saving bonus if you are transferring highly valued assets) and removes the assets from the donor’s estate as the transfer is irrevocable. A DAF offers benefits through the three tax lenses we looked at previously: ordinary income tax, capital gains tax, and inheritance tax.
Let’s take an example: Mary gives $ 20,000 a year to the Alzheimer’s Association after her mother has been affected by the devastating disease. Instead of giving $ 20,000 per year, Marie decides to pool five years of donations ($ 20,000 x 5 = $ 100,000) to a fund advised by a donor. Once in the DAF, Mary can recommend grants to any 501 (c) (3) qualified organization in any way she sees fit. She has the flexibility on how the funds are distributed to the charity.
First benefit – Income tax: Mary can take the entire deduction in the year she donates to the donor advised fund, which is usually limited to 30% of the AGI for non-cash donations (see second benefit below ).
If Mary’s AGI is not high enough to allow the full deduction, it will carry over for five years or until the deduction is fully used, whichever comes first. If the DAF is coupled with a Roth conversion, the Roth conversion will increase income by the amount of the conversion. Grouping charitable donations over multiple years is likely to create a scenario where the taxpayer is able to itemize their deductions on their Schedule A instead of taking the standard deduction.
Second advantage – Capital gains tax: Let’s say Mary has a low core stock that she has held in her revocable trust account for several decades. If she bought the stock for $ 10 in 1980 and it’s worth $ 100 today, Marie would realize $ 90 in capital gains when she sold the stock and then wrote a check to the Alzheimer’s Association.
If Mary donates the shares directly to the CFO, she gets the full $ 100 deduction and doesn’t realize any capital gain. Assuming Mary is in the highest tax bracket, this saves her $ 18 in tax ($ 100 – $ 10 = $ 90 x 20% of the LTCG earnings tax rate) and provides the full $ 100 to the Alzheimer’s Association versus the $ 82 it would give after tax. Mary gets a higher deduction and the charity receives a larger donation.
Under the president’s proposed plan, the capital gains tax savings could almost double if Mary earns more than $ 1 million in income per year. Note that the 3.8% Medicare surcharge would be added in both illustrations but is excluded for simplicity.
Third advantage – Estate tax: Marie reduced the value of her estate by $ 100,000 since the transfer to the CFO is irrevocable. If the inheritance tax exemption is reduced as part of the president’s tax reform, a CFO provides a planning tool to remove assets from an individual’s estate. Assets outside of an individual’s estate are not subject to inheritance exclusion or tax. The irrevocable nature of the donation also means that once the asset is in the DAF, Marie cannot take it back or use the funds for non-charitable purposes.
As you can see, a Roth conversion and DAF match can be a fantastic strategy to offset higher income for those who would rather support meaningful causes in their lives than write 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 paid financial planner who believes that a successful counseling relationship involves compassionate conversations and planning tenacity.
The information presented is for educational purposes only and is not intended to make an offer or solicitation for the sale or purchase of any specific securities, investments or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to consult with a qualified financial advisor and / or tax professional first before implementing any strategy discussed here. Past performance is not representative of future performance.
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Email Jeffrey Levine, CPA / PFS, Director of Planning at Buckingham Wealth Partners, at: [email protected]