December of 2009, I had a client ask me about converting his IRA to a Roth IRA in 2010. This was a common request due to the removal of the income limitation for the conversion in 2010, but this client also had other key planning points. This client was not married but had a life partner significantly younger than he, who he wanted to pass considerable assets during his lifetime. This client was also contributing annually to his favorite charity. Additionally the client was closing in on 70. At this age it is not usually prudent to pay the taxes and convert from a traditional to a Roth because the client would not have enough time to overcome the taxes he would have to pay up front. However, 2010 is also special because the itemized deduction limitation has been phased-out. This means that high income earners would not be limited to the amount of itemized deductions allowed.
If this client were to combine his Roth conversion with his charitable giving he may be able to offset the tax on the conversion.
After completing a comprehensive financial plan for this client, it was apparent he could convert a $100,000 IRA and offset this with a corresponding $100,000 charitable gift and still meet his other financial goals. This gift could be either outright or in the form of a trust. In this case the client was currently giving $10,000 to his charity every year. If he were to accelerate this gift and give 10 years worth in 2010 he could completely offset the income caused by the Roth conversion.
This strategy only works if the IRA being converted doubles the ordinary income of the client and the client gifts cash to the charity. The IRS places limits on the amount of charitable contributions based on adjusted gross income and the type of asset gifted. For cash contributions the IRS allows up to 50% of adjusted gross income to be deducted in the current year. The rest is carried forward for 5 years.
In this case if the client makes roughly $100,000 per year, and converts $100,000 traditional IRA to a Roth, he effectively doubles his income, this allows for up to a $100,000 deduction in 2010. This would virtually eliminate the extra tax caused by the Roth conversion.
But what if the client needed the income from his investments to maintain his standard of living? In this case consideration would be made for a charitable remainder unit trust (CRUT). A CRUT with an initial value of $375,000 and a 6% payout would give the client about $22,500 in income the first year. This income would fluctuate each year but it would be based on a 6% payout from the balance each year for 10 years (from NumberCruncher, assuming a 3.4% AFR). The remainder would go to the charity of your choice. The charitable deduction allowed would be $103,923.75 in the current year.
In the case of this client, he wanted to give to charity every year and transfer money to his life partner. A charitable lead unit trust (CLUT) would work best in this situation. When the goal is to transfer assets to someone else the limitation is not the charitable deduction but the amount of assets the client would like to remove from his estate. In this case, $1,000,000 was used. If the initial value in the CLUT is $1,000,000, and the payout was 5% annually with an assumed 6% growth rate, the charitable deduction would be $395,480. The life partner would end up with $1,072,247 after 10 years assuming a distribution rate of 5% and a growth rate of 6%. This would also result in a taxable gift by the client to the beneficiary of $604,520. Even with this tax the client, removes $1,000,000 and its growth from his estate, contributes annually to his charity for 10 years, and transfers assets to his life partner.
The removal of the income limitation and limitations for itemized deductions in 2010 has created some unique planning opportunities. Planning is driven by the client’s overall goals. If a client is charitably inclined and wants to convert a traditional IRA to a Roth IRA, 2010 will be a good year to do this. Clients can offset the tax with an outright gift, a charitable remainder trust or a charitable lead trust. The planner needs to look at and be cautious of the income limitations of the gift, the type of asset that is being donated, as well as the type of charity.
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