Is the IRS your favorite charity?

(… or, How to save some of those pesky taxes on IRA conversions, while also benefiting the charities of your choice.)

If you converted some or all of your IRA accounts to Roth IRAs in 2010, or plan to do so this year or in the future, you will be looking at a hefty add-on to your income tax bill in the near future. If you converted in 2010, and accepted the default of deferring the income recognition to 2011 and 2012, you may not have been thinking about those checks you will have to write to the IRS in 2012 and 2013.  But alas, time marches ceaselessly forward, and you’ll soon be feeling that deferred pain.

So, what if I told you that instead of paying all that cash over to the IRS, you could donate a chunk of it to your favorite charity instead?  That you could send it to the Red Cross to help with the Japan relief efforts, to the SPCA to save little puppies and kittens, to an organization that fights cancer, AIDS, or another nasty disease? Now maybe with our deficit being what it is, you might feel OK about sending your check to the IRS. But if you’d rather support your church, school or another tax-exempt charity over the next several years, while getting a hefty income tax deduction now to offset that pesky Roth income, read on.

Any gift to charity will generate a tax deduction. But with a straight gift, you deduct exactly the amount you give, when you give it. To get an $80,000 tax deduction now, you’d have to give away $80,000 now. That money would no longer be earning interest or dividends, or growing in value as it would if invested in growth stock, art, or other appreciating investments – it would be gone.   But with a charitable trust, you can accelerate the deduction into the year when the trust is established, but actually hand over the money in the future, with it continuing to grow or generate income in the meantime. This can have tax and financial benefits for both you and the charity.

Either a charitable remainder trust (where you place assets in trust, draw back payments over time for yourself or your loved ones, with whatever’s left at the end of the annuity period going to the charity) or a charitable lead trust (where the assets are placed in trust, with payments going to the charity for a period of years, and the remainder coming back to you or going to your chosen beneficiaries) can generate a sizeable income tax deduction in the year that it is created.  Because the applicable Federal interest rates are low, a charitable lead trust is more favorable now, while a charitable remainder trust tends to be better when the rates are higher. (Consideration should also be given to potential estate tax issues, which are not addressed here.)

Ordinarily, the amount of charitable deduction that you can claim is limited by your AGI (adjusted gross income). But when you do a Roth conversion of a few hundred thousand dollars, that amount will be included in your AGI for the year of the conversion (or, if you converted in 2010, half of it can be included in your 2011 AGI and half in 2012). So that will greatly increase the amount of charitable deduction that you can take for the year, as well.  If you have other income equal to the amount of Roth conversion income, and you have the money available (not including what’s still in your retirement accounts) to fund a charitable trust, it’s possible that you could get a charitable deduction to completely offset the additional Roth income!

Here’s an example. Let’s say a taxpayer has liquid assets of $500,000, not including retirement funds; AGI (not counting Roth conversion income) of $150,000; and has converted $400,000 of IRAs to Roth IRAs in 2010.  The conversion would add about $200,000 of taxable income to the taxpayer’s AGI for 2011 (and the same amount in 2012). So instead of having AGI of $150,000, he would have $350,000 (and would now be in the 33% bracket, rather than 28%, depending on deductions). Ouch. And even ouchier if you have state income tax to worry about as well.

But let’s say that Mr. Taxpayer now takes $250,000 of his liquid assets and establishes a Charitable Lead Trust to benefit his favorite charity, the Kauai Robotics Alliance (KRA) (MY favorite charity) for the next 10 years.  If the funds are invested to earn 6% annually, and the trust pays out 12,500 annually, the KRA will get $12,500 per year for 10 years, a total of $125,000. At the end of the 10 years Mr. Taxpayer will get back $282,951.  And this year, when he needs and can use it, he will be able to take a charitable income tax deduction of about $110,000.  That will reduce his extra taxable income by $110,000, saving about $36,000 in Federal taxes (and possibly more in state taxes) and getting $125,000 to the little robot builders (they might even name their next robot after Mr. Taxpayer).   He could set up another trust in 2012, to offset the other half of his Roth conversion income, and benefit a different charity. With two such trusts, Mr. Taxpayer would have donated $250,000 to his favorite charities, at a net cost to him of only about $177,400, thanks to the tax savings. If state income taxes are about 7.5%, there would be an additional $16,500 in state tax savings).

Now, there is a little downside.  To get the income tax deduction when the trust is funded, Mr. Taxpayer must sign on to pay the tax on any income earned by the trust during the 10-year period. If the trust earns 7% per year,that will add about $17,500 (for each trust, or $35,000 for both) to his taxable income each year.  That can be avoided if the trust invests in tax-exempt bonds, or reduced if the income is in the form of capital gains (taxed at a lower rate). Even if not avoided or reduced, it still serves to ‘spread the pain’ of the additional tax over many years, rather than having to pay it all at once, immediately.

So, if you have made a Roth conversion (or plan to make one), and the IRS is NOT your favorite charity, you might want to talk to your advisors about setting up a charitable lead trust to shift some of that booty away from the government coffers, and into the hands of your favorite charities.

Published in: on June 27, 2011 at 10:59 pm  Leave a Comment  

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