The obstacle for many people who are thinking of converting their traditional IRAs to Roth IRAs is the cost of the conversion. You have to include the converted amount in gross income as though it were distributed to you. The amount, after deductions, will be taxed at your ordinary income tax rate. As we discussed in past visits, it’s important to pay the taxes on the conversion from funds outside the IRA. Take the taxes from the IRA, and the cost of conversion increases. You’ll need to leave the money compounding in the IRA longer for the conversion to make sense.
The payoff from a conversion is enhanced when you can reduce the tax bill on the conversion or reduce the tax cost of raising cash to pay the taxes. There are several strategies that could reduce the taxes on your IRA conversion.
? Reduce gross income. A range of strategies could help reduce gross income. Deductible business losses from an S corporation, partnership, LLC, or a proprietorship reduce gross income. There are a number of hurdles in the tax code to take the deductions. For example, you must materially participate in the activity, and it must be a profit-seeking trade or business and not a hobby. But if you qualify and can time business income and expenses to generate a loss, it will reduce the cost of the IRA conversion.
You may have enough flexibility to reduce some income payments for the year. Reduce optional distributions from IRAs and annuities. Defer salary from employment. Avoid taking capital gains by limiting asset sales during the year of the conversion. Take capital losses to offset gains. (We’ll discuss this one in more detail shortly.)
? Reduce adjusted gross income. Gross income minus certain deductions leads to adjusted gross income (AGI). The deductions include self-employed retirement plan contributions, health premiums for the self-employed, and self-employment taxes.
? Increase charitable contributions. This is a strategy for people who are inclined to make significant charitable contributions each year or through their estates. Advancing the contributions to years when an IRA is converted can make a lot of sense.
You don’t have to actually give all the money to charity the year of the conversion. You can donate to a donor-advised fund, such as those run by Schwab, Fidelity, and many localities. Most funds have minimums of $5,000. You can direct payments from the fund to charities over time, but you deduct the charitable contribution the year you donate to the fund. Be aware that you can’t get the money back once it is donated to the fund.
This strategy obviously is only for funds you plan to give to charity over time. You’re considering accelerating them to reduce taxes on the conversion. Since you are giving the money away, it is not a good strategy for someone who wasn’t planning to donate or can’t afford to. But when you are charitably-inclined, accelerating the contributions reduces the cost of the conversion and could make better use of the deductions than stretching them out over time.
? Give appreciated assets. When you don’t have enough cash to accelerate charitable contributions, you want to look at donating appreciated assets. When appreciated securities and real estate are donated, you deduct the fair market value on the date of the contribution. You don’t owe capital gains taxes accrued during your ownership. This is a way to accelerate charitable contributions without tapping cash or incurring capital gains. Go through your portfolio and consider donating mutual funds, stocks, or real estate that are substantially higher than your purchase price.
? Take capital losses. Suppose you have significant paper losses in your portfolio. These assets have strategic value, but most people benefit from them only over time. Capital losses offset capital gains for the year dollar for dollar. Additional losses up to $3,000 can be deducted against other income. Any left over losses can be carried forward to future years and used in the same way.
When you have significant paper losses or carryovers of past losses, they make it cheaper to sell appreciated assets to generate cash for the Roth conversion. You sell both the losing assets and the appreciated assets. The losses shelter the gains from taxes. You’ve raised the cash to pay the taxes on the IRA conversion without incurring additional taxes. Or you can consider donating the cash to charity so the deduction will offset some of your IRA conversion taxes. Run the numbers both ways to see which has the best cash flow.
The year you convert a traditional IRA or employer plan to a Roth IRA is likely to be the year with the highest taxable income of your life. Once you determine a conversion is a good idea, look for ways to reduce the tax cost and make it an even better idea.
RW September 2010.