In our June 2009 issue of Personal Planning Strategies, we explained that, beginning in 2010, all taxpayers, regardless of their income levels, will be eligible to take advantage of the opportunity to convert some or all of their traditional individual retirement accounts or other qualified retirement plans ("IRAs") to one or more Roth IRAs. Additionally, on September 20, 2010, President Obama signed into law the Small Business Jobs Act of 2010, which authorizes 401(k) plans to allow participants to rollover pre-tax 401(k) accounts into Roth 401(k) accounts. This will allow all of the Roth IRA advantages to be made available to 401(k) participants (in the rest of this article we will refer only to Roth IRAs but the same rules are applicable to rollovers to Roth 401(k) plans). As explained in our June 2009 issue, the one major drawback of converting an IRA to a Roth IRA is that the entire conversion amount is taxable. Despite the taxable income, many clients have already converted their IRAs and many plan to do so prior to the end of the year. In this issue, we explain how you can use certain charitable giving techniques to offset that taxable income, thereby enhancing the benefits of a Roth conversion.

Revisiting the Benefits of Roth Conversions

With a traditional IRA, you make contributions with "pre-tax" dollars, and your investment is allowed to grow on a tax-deferred basis; that is, amounts earned, including the contributions, earnings and appreciation, are not taxed until distributions are made. Traditional IRAs are subject to mandatory distribution requirements when the account owner attains age 70 ½, also known as "required minimum distributions" or RMDs. The forced distributions result in income tax to the account owner each year after attaining age 70 ½, while continuously diminishing the tax-deferred amount remaining in the account (subject to offsetting earnings and growth).

On the other hand, contributions to Roth IRAs are made with "after-tax" dollars and, as a result, the appreciation inside a Roth account grows tax-free. Therefore, there is no income tax when money is distributed from a Roth account in retirement or when distributions are made to the account owner or the beneficiaries. In addition, Roth IRAs are not subject to RMDs when the account owner attains age 70 ½. Consequently, if the account owner converts a traditional IRA to a Roth IRA, he or she will not be required to take RMDs during life. After death, a beneficiary receiving a Roth account will be required to take RMDs over his or her life expectancy. However, unlike a traditional IRA, distributions received by beneficiaries from an inherited Roth IRA will not be subject to income tax when received (they are income tax-free)! Thus, after death, the heirs, if they wish, will be able to keep utilizing the Roth IRA as a "tax shelter" and obtain tax-free growth within the IRA during their lifetimes and not pay any income tax on the RMDs that they receive each year over their lifetimes.

Under prior law, a traditional IRA could be converted to a Roth IRA only when the account holder's modified adjusted gross income was $100,000 or less. Beginning in 2010, the income limit no longer applies. Thus, all individuals are now entitled to convert a traditional IRA to a Roth IRA. If you convert, you generally must include the conversion amount in your gross income in the year of the conversion. However, if you convert in 2010, you are eligible to pay one-half of the taxes related to the converted amount in 2011 and the other half in 2012.

Using Charitable Giving Techniques to Offset Income Tax

Because the conversion to a Roth IRA will generate taxable income, you may want to consider using one or more charitable giving techniques to offset the income. The type of charitable giving technique you choose will depend on your charitable goals and the amount of income you will need to recognize as a result of the Roth conversion.

The simplest method is an outright gift to charity of cash or property. Keep in mind that there are certain limitations on how much of the gift you can deduct in any given year. Generally, you may deduct up to 50% of your adjusted gross income for cash gifts and 30% for gifts of property, such as stock. Also, generally speaking, any amounts in excess of the limitation may be carried over as a deduction in the five succeeding years. Thus, if you had excess contributions in the last five years, you can use the carried-forward amount to offset all or a portion of the income on the Roth conversion.

Another option is a charitable gift annuity. Generally, a charitable gift annuity is a transaction in which you transfer cash or property to a charitable organization in exchange for the charity's promise to make fixed annuity payments to you for the rest of your life, or to you and your spouse for the rest of your lives and the life of the survivor. Payments can begin immediately or can be deferred for a period determined by you and set forth in the annuity contract. The charitable gift annuity is treated, in part, as an outright charitable gift, and, in part, as the purchase of an annuity contract. You receive an up-front charitable deduction for the gift portion of the amount transferred, which is equal to the excess of the fair market value of the property transferred over the present value of the annuity, as determined under IRS tables. A portion of the annuity payment is taxable as ordinary income, but the remaining portion is considered a tax-free return of principal. Charitable gift annuities may be particularly attractive if you are looking for income to replace some or all of the RMDs you would have otherwise received from your traditional IRA.

A charitable remainder trust ("CRT") works very similar to a charitable gift annuity, but typically is used when more substantial gifts are planned. A CRT is a trust to which you contribute assets and which pays you and/or your spouse a fixed dollar amount (or a fixed percentage of the value of the CRT assets) for a specified number of years not to exceed 20 years, or for the rest of your life or lives. At the end of the term, the assets remaining in the trust pass to one or more charities. The annual amount paid to you must be at least 5%, but not more than 50%, of the initial fair market value of the trust's assets. And, the value of the remainder interest passing to charity, as determined under IRS tables, must be at least 10% of the initial fair market of the trust's assets. You receive a current income tax deduction equal to the value of the remainder interest. Your annuity payment is treated as a combination of ordinary income, capital gain, tax-exempt income and a return of capital, depending on a variety of factors. Similar to the charitable gift annuity, the CRT is a good technique for those who wish to generate a current income tax deduction to offset income from a Roth conversion and also want to replace some or all of the RMDs they would have otherwise received from the traditional IRA.

Another available technique is a "grantor" charitable lead annuity trust ("CLAT"). A CLAT is a natural choice if you already plan to make significant gifts to charity over the next several years. By using a CLAT, you can accomplish that goal while accelerating the income tax deduction in the year you create the CLAT and, in most cases, passing wealth to your children and grandchildren, or other non-charitable beneficiaries, estate and gift tax free. A CLAT is a trust to which you contribute assets, and which pays a fixed dollar amount (or a fixed percentage of the value of the CLAT assets) to one or more charities for a specified number of years. You receive a current income tax deduction equal to the present value of the interest passing to charity. At the end of the annuity term, the assets remaining in the CLAT pass to one or more non-charitable beneficiaries, such as your children or grandchildren, or trusts for their benefit. When you contribute assets to a CLAT, you make a taxable transfer equal to the present value of the remainder interest that will pass to the non-charitable beneficiaries. The value of the remainder interest is calculated by using the "7520 rate" in effect in the month you transfer the property to the CLAT (or, if you elect, the 7520 rate in effect for either of the two months preceding the transfer). The CLAT can be structured so that it is "zeroed out," thereby resulting in a small or non-existent gift to the non-charitable beneficiaries. If, over the annuity term, the CLAT generates total returns higher than the applicable 7520 rate, the excess growth passes to the non-charitable beneficiaries estate and gift tax free. The lower the 7520 rate, the greater the charitable deduction will be and the greater the potential will be for a tax-free wealth transfer. Thus, because the 7520 rate is currently at its historical low, and it is anticipated to increase in the coming years, now is the ideal time to do a CLAT, particularly if you can use the charitable deduction to offset income from a Roth conversion.


The forgoing techniques are but a few of the ways to use charitable giving to offset the income tax that you would otherwise incur by converting your traditional IRA to a Roth IRA. You should consult with an attorney who is familiar with IRAs and charitable giving techniques to implement the techniques that are available to you to achieve your specific goals. By utilizing these techniques and others, you can realize the benefits of Roth IRAs—tax-free growth with no RMDs—while minimizing or eliminating the income tax drawbacks of converting.