Tax-savvy Roth IRA conversions

Before you convert your traditional IRA to a Roth IRA, consider two tax-savvy strategies.

Tax-savvy Roth IRA conversions

The benefits of a Roth IRA are clear: The potential for tax-free growth and tax-free withdrawals for you and your heirs.1

But if the only way for you to have a Roth IRA is via a conversion, be prepared to pay income taxes on the amount you convert.

Here are two ways to help manage that tax hit. One even lets you do some good by combining the conversion with a charitable deduction.

Spread the cost

A common way to manage taxes on a Roth IRA conversion is to spread the conversion over a few years. That way you spread the tax bill too, as well as prevent the conversion from bumping you into a higher tax bracket.

Consider this hypothetical example. Imagine a married couple, the Mullens, who file jointly, with $87,000 in taxable income in 2010. They could convert up to $50,000 to a Roth IRA and stay within their 25% tax bracket (which for 2010 is taxable income between $68,001 and $137,000). As long their tax rate and income generally stay the same, they could convert this amount yearly until they reach the total amount they want to convert. The potential benefit: They maintain a consistent tax rate when converting (provided their situation or the tax rates don’t change in the ensuing years). If they converted more than $50,000, they would move into the 28% bracket, meaning higher taxes on income over $137,000.

Some flexibility is built in for 2010 conversions. You have a one-time opportunity to defer the taxable income and evenly spread it between your 2011 and 2012 tax returns. Specifically, you don't include any of the taxable income from the conversion on your 2010 tax return. Instead you report half of the conversion as income in the 2011 tax year and the remainder in 2012. (This is the default option in 2010.) 

Sound good? A wrinkle: Tax rates are scheduled to go up in 2011 for most taxpayers. Because of the higher rates, there’s a chance you could end up paying more tax on your conversion with this method than if you had included all of it as taxable income in 2010.

There are other challenges. 

Estimating your taxable income can be tricky until you’ve received all of your tax reporting documents, which typically aren’t available until well after December 31. Your conversion, however, must be completed prior to December 31. So your income may end up being higher or lower than you expected. 

One solution: a recharacterization. It allows you to “undo” some, or all, of a conversion made the prior year. You have until October 15 of the year following conversion to recharacterize.2 For example, say you discover in January 2011 that your income was higher than you expected in 2010 after you converted $50,000 to a Roth IRA. Because of that, $10,000 of the conversion will be taxed at the 28% rate instead of 25%. You could recharacterize that $10,000 to bring your amount back into the 25% bracket. A conversion completed in 2010 can be partially or fully “undone” until October 15, 2011.

Another challenge: If you’re near the top of your bracket, it may take a long time to convert the total amount that you want without moving into a higher bracket. For instance, if you file jointly and your taxable income is $130,000 in 2010, you could only convert $7,300 if you wanted to stay within the 25% bracket.

Make a charitable contribution

Tax deductions can help offset the tax cost of a Roth IRA conversion and perhaps allow you to convert a larger amount at a lower tax cost. Among the more flexible of deductions, especially for high-income earners, are charitable contributions. 

The tax deduction for a contribution to a public charity can be up to 50% of your adjusted gross income (AGI) for cash donations and up to 30% for donations of securities (generally deductible at fair market value when long-term appreciated securities are gifted) in a given year. And if your contribution exceeds these limits, the remainder can generally be carried forward for up to five years.

To determine your deduction, you generally add the taxable portions of your conversion amount to your AGI. For example, if you are planning to convert $200,000 to a Roth IRA and expect your AGI will be $150,000, your estimated adjusted gross income (AGI) would be $350,000 after the conversion. This means you could potentially deduct up to $175,000 (50% of $350,000) of a charitable cash contribution, which could significantly reduce the tax impact of conversion.

Consider this hypothetical example: Richard and Ellen Nettle, 57 and 58, respectively, are considering a large Roth IRA conversion in 2010. They have $500,000 in an eligible rollover IRA and $400,000 in a taxable brokerage account—which could be used to pay the taxes on the conversion or to make a charitable donation. This year, the Nettles estimate their total income will be $145,000 and they’ll have approximately $34,000 in deductions. As a sales executive, Richard is concerned that in the coming years his income will be higher, pushing them into a higher tax bracket. They’d like to convert as much of their rollover IRA at the lowest possible tax cost as soon as possible. The Nettles regularly give to charity and could make a $112,000 one-time gift to one or more charities this year from their taxable brokerage account.

Take a look at the potential taxes on their Roth IRA conversion with and without a charitable donation.

Charitable gift donation may help reduce taxes

As the chart above shows, the Nettles total estimated tax cost for a conversion in 2010 would be $39,200 less if they make a charitable donation the same year they convert. It would allow them to effectively keep the tax rate on their conversion at 25% ($124,845/$500,000). 

Their “out-of-pocket” expense however, is $72,800 more with a charitable gift, an important consideration. On the other hand, if the $112,000 that the Nettles gave to charity included securities with long-term capital gains, by gifting them they also avoid taxes on the realization of those gains. In some cases, that can significantly reduce the effective after-tax cost of a charitable contribution.

One note: Our hypothetical example only includes current federal taxes. State and local taxes could also have a significant impact. And a higher AGI may impact other deductions as well. For these reasons, it’s important to speak to a tax adviser as part of a Roth IRA conversion decision.

Let’s look at some smaller numbers. For example, if your taxable income is near the top of the 15% bracket ($68,000 for joint filers in 2010) before a Roth IRA conversion, combining a charitable gift of $20,000 with a $50,000 conversion, and the assumptions stated above, results in a $7,500 tax cost—$5,000 less than without the charitable contribution. It also keeps you in the 15% tax bracket. But your cash outlay would be $15,000 more.

What if you prefer giving regularly rather than making a single large gift to charity when you convert to a Roth IRA? You may want to consider a donor advised fund, or DAF. DAFs, which are programs offered by public charities, allow you to make a charitable contribution in a given year, take an immediate tax deduction, and offset the cost of a Roth IRA conversion that year. You can then support charitable causes over several years. Effectively, with a DAF, you front-load a “ready reserve” of charitable dollars that can be used over time to support many charitable causes.

Some challenges to the charitable-offset strategy:

  • Gifts to charity are irrevocable. Unlike Roth conversions, which can be “undone,” or recharacterized, gifts to a charitable organization, including DAFs, are final. So if you decide to recharacterize, you’d still need to take the charitable deduction, and it might be at lower tax bracket than you expected.
  • Charitable deductions may be worth more if taxes go up in the future, because they may be deducted against a higher tax rate.

Conclusion

Managing the tax impact of a Roth IRA conversion requires careful analysis. Ideally, you should include it as part of a review with a financial or tax adviser to fully investigate whether you’re likely to benefit from a Roth IRA conversion and how to execute it appropriately.

Next steps


1. A distribution from a Roth IRA is tax free and penalty free provided that the 5-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, die, become disabled, or make a qualified first-time home purchase.

2. To be eligible to recharacterize you must file your taxes or an extension by the April 15 deadline.

Chart assumptions: If they converted the entire rollover IRA amount to a Roth IRA, the estimated actual tax cost of their conversion will be $164,045. The taxable income with no conversion and no charitable contribution was calculated ($145,000 wages less itemized deductions of $34,000 = $111,000). Taxable income with a conversion and any applicable charitable donation was calculated (($145,000 wages + Conversion Amount) less itemized deductions of ($34,000 + Deductible Charitable Donation). Taxes were calculated by applying the 2010 federal ordinary income tax rates for a married couple, filing jointly, for each of the taxable income amounts determined in the prior two steps: 10% on first $16,750 of taxable income; 15% on next $51,250; 25% on next $69,300; 28% on the next $71,950; 33% on the next $164,400; and then 35% on any remaining amount. The difference between those two tax results is the estimated actual tax cost of the conversion. With no conversion and no charitable contribution, taxes would have been $20,112. But if the couple had sufficient additional assets to also make total qualified charitable donations of $112,000 that same year, the estimated reduced tax cost of conversion would be $124,845—which is $39,200 less than it would have been without the offsetting charitable donations.

As with any tax planning strategy, there may be additional considerations that pertain to your personal situation. Other strategies may provide more flexibility and similar savings, including utilizing other deductions and/or converting your IRA over several years. Please consult with your tax adviser.

Assumes donation to 501(c)3 public charities with 50% limit on cash contributions and a 30% limit on security contributions in aggregate as a percentage of adjusted gross income (AGI). Gifts to charity are irrevocable and nonrefundable.

Information provided is general and educational in nature. It is not intended to be, and should not be construed as, legal or tax advice. Fidelity does not provide legal or tax advice. Content provided relates to taxation at the federal level only. Availability of certain federal income tax deductions may depend on whether you itemize deductions. Rules and regulations regarding tax deductions for charitable giving vary at the state level, and laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of the information provided. Charitable contributions of capital gain property held for more than one year are usually deductible at fair market value. Deductions for capital gain property held for one year or less are usually limited to cost basis. Consult an attorney or tax adviser regarding your specific legal or tax situation.

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