You have probably heard of the Roth IRA. You may have even heard that a Roth IRA is “better” than a traditional IRA.
You fund a Roth with after-tax dollars, which means that you’ve already paid taxes on the money you put into it. In return for no up-front tax break, your money grows tax free. That means that when you withdraw it at retirement, you pay no taxes.
This article assumes that you have a basic understanding of the other advantages and disadvantages of a Roth IRA.
There are two ways to get money in your Roth IRA: a Roth contribution or a Roth conversion.
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There are income restrictions on making contributions to a Roth IRA. However, these income restrictions do not apply to Roth IRA conversions. So while not everyone may be able to contribute to a Roth IRA, most people can convert to a Roth IRA. But, a common roadblock to conversion is having cash flow to pay the tax liability.
A Roth conversion is treated as a taxable liquidation of your traditional IRA followed by a non-deductible contribution to the new Roth account. So the “cost” of a Roth conversion is paying income taxes on the amount you convert in the year of conversion. The “benefit” is that you give that money the potential to grow tax free and ensure that you have tax-free withdrawals for you and your heirs.
There are two key ways to help you manage the tax bite and reduce the tax cost of a Roth conversion.
Spreading the conversion over multiple years may help reduce the tax cost of a Roth conversion
A common way to manage taxes on a Roth IRA conversion is to spread the conversion over a few years. This may prevent the income from the conversion from bumping you into a higher tax bracket and allow you to spread the tax bill over multiple years.
For example, if you are a married couple, filing jointly, with $106,400 in taxable income in 2013, you could convert up to $40,000 to a Roth IRA and stay within the 25 percent tax bracket (which for 2013 is taxable income between $72,501 and $146,400).
If you converted more than $40,000, additional amounts would be taxed at the 28 percent marginal rate.
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As long as your tax rate and taxable income generally stays the same, and tax rates don’t change, you could convert $40,000 each year until you reach the total amount you want to convert. (Note: Although you may have some control over your taxable income, future tax rate increases are outside of your control.)
However, things aren’t always as simple as in the example above. For higher-income filers, phase-outs on itemized deductions and personal exemptions can make computing taxable income more complex.
Also, because the Roth conversion must be completed by December 31, it may be difficult to estimate your taxable income. Tax reporting documents are typically not available until well after Dec. 31. So your income may end up being higher or lower than you expected.
But there is still a potential “way out” should you change your mind: a re-characterization allows you to “undo” some, or all, of a conversion. In fact, you have until October 15 of the year following conversion to re-characterize. A conversion completed in 2013 can be partially or fully “undone” until Oct. 15, 2014.
A charitable donation may help reduce the tax cost of a Roth conversion
Another tax-savvy strategy is to use the tax deduction for charitable contributions to offset the income from a Roth conversion. Used effectively, tax deductions for charitable contributions can allow you to convert a larger amount at a lower tax cost.
The tax deduction for a contribution to a public charity can be up to 50 percent of your adjusted gross income (AGI) for cash donations and up to 30 percent for donations of securities (generally deductible at fair market value when long-term appreciated securities are gifted) in a given year. If your charitable contribution exceeds these limits, the excess can generally be carried forward for up to five years.
To estimate the amount of the charitable deduction you may be able to claim, you 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 before the conversion to be $150,000, your estimated adjusted gross income (AGI) would be $350,000 after the conversion.
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Therefore, you could potentially deduct up to $175,000 (50 percent of $350,000) of a charitable cash contribution, or $105,000 (30 percent of AGI) of a charitable donation of securities with long-term appreciation.
Contributing securities with capital gains would result in an even more savvy tax move. If the donation to charity includes securities with long-term appreciation, you would also avoid taxes on the realization of those gains.
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.
DAFs allow you to make a charitable contribution to the DAF in a given year, and take a tax deduction that year. In effect, you create a reserve of charitable dollars that you distribute over time to support charitable causes.
Using a DAF as part of a Roth conversion strategy would mean that you could take a tax deduction for the entire amount of the contribution to the DAF in the year that you do a Roth conversion, which could help offset the taxes in that year.
A final point to note: charitable deductions may be worth more if taxes go up in the future, because they may be deducted against a higher tax rate.
In summary, although you take a current year tax hit from a Roth conversion, it could be a savvy tax move in terms of future tax savings. Using the strategies above can help reduce the tax cost of a Roth conversion.
Please consult with your tax professional regarding your particular situation. A tax professional who takes a holistic view of your financial situation can provide guidance on whether you’re likely to benefit from a Roth IRA conversion and how to execute the conversion as one aspect of comprehensive tax planning strategy.
Lisa Hay, CPA, is President and founder of Ascend Financial, LLC, a fee-only financial and retirement planning firm. You can follow Lisa on Twitter: @lisahaycpa, connect with her onLinkedIn, or email her at email@example.com.
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