This is the seventh article in a series of eight articles dealing with the topic of converting your traditional IRA to a Roth IRA. For other articles, see:
Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 8 – Putting It All Together
Individuals who make significant charitable gifts have additional considerations when evaluating whether to convert a traditional IRA to a Roth IRA. A lot of my clients plan to give at least a portion of their traditional IRA to charity upon their death. In addition to wanting to make charitable gifts, these clients realize that the bequest to charity will avoid income taxes and estate taxes. Individual beneficiaries would have to pay income taxes if they received the IRA. Furthermore, if the IRA owner’s estate is larger than the allowable estate tax exemptions, there will also be estate taxes imposed upon the portion of the IRA that is paid to children.
Individuals who plan to give their IRA to charity have less to gain by making a conversion. If you are planning to leave a portion of your IRA to charity, a conversion will cause you to pay income taxes now that you might not otherwise be paying later. In certain circumstances, you can still justify making the Roth IRA conversion. Nevertheless, I have discouraged my clients who plan to leave their entire IRA to charity from making the Roth conversion.
Some IRA owners intend to leave only a portion of their IRA to charity. Assume that Mrs. Brown has a $500,000 IRA and the beneficiaries are designated as follows: $100,000 to XYZ Church, $100,000 to XYZ University, and the balance to children.
Mrs. Brown can convert a portion of the IRA to a Roth IRA. Ideally, she will not convert beyond the amount which will allow there to be at least $200,000 in her traditional IRA upon her death. Some guesswork will be required to determine how much to leave in the traditional IRA so that there is at least $200,000 at the time of her death because there will be earnings and required minimum distributions during her remaining lifetime.
Assume that Mrs. Brown expects to live to age 90 and her investment advisors recommend that she leave at least $300,000 in her traditional IRA so that there will be at least $200,000 left when she dies. She should convert the entire $500,000 and place $100,000 in five separate accounts. No later than October 15 of the year following the conversion, she will recharacterize three of the accounts, or perhaps more if investments have performed poorly. This technique allows her to make the conversion with the best performing accounts while leaving sufficient funds in the traditional IRA to make the charitable bequests at the time of her death.
Your lifetime charitable giving is also relevant to the Roth conversion analysis. You will recognize income in the year of the conversion. For conversions in the year 2010, you can elect to recognize 50% of the income in the year 2011 and 50% in the year 2012. If you know that you will be making large charitable gifts in the future, you may choose to accelerate those gifts into the year of the conversion (or into 2011 and 2012 for conversions in the year 2010).
If you need a charitable deduction now, but do not want the charities to receive the funds until later, your charitable donation can be “escrowed” in a donor advised fund or a private foundation. Both of these structures allow you to identify the charitable recipients and make the actual charitable gifts in a later year.
In summary, you should consider accelerating charitable gifts to reduce income taxes attributable to a conversion of your traditional IRA to a Roth IRA. You should not convert the portion of your traditional IRA that you intend to leave to charity upon your death.