April 2, 2020
Converting Traditional IRA to ROTH with Charitable Contributions
Posted by COVID-19 Rapid Response Team
With traditional IRAs at depressed values, consider converting the IRA to a ROTH IRA in combination with an increase in your charitable contributions. The result could be zero tax on the conversion.
A Roth IRA is an IRA that, except as explained below, is subject to the rules that apply to a traditional IRA.
- You cannot deduct contributions to a ROTH IRA.
- Qualified distributions from a ROTH IRA are tax-free.
- You can make contributions to your ROTH IRA after you reach age 70 ½.
- You can leave amounts in your ROTH IRA as long as you’re living, as there are no required minimum distributions.
- You can leave your ROTH IRA to your heirs and they can stretch out distributions over their lifetime income tax-free.
For charitable contributions – the limit that applies to a contribution depends on the type of property you give and which category of qualified organization you give it to. Also, the amount of the contribution you can deduct generally is limited to a percentage of your adjusted gross income (AGI).
AGI Limitations (in general):
- If you make “cash” contributions during the year to a qualified organization, your deduction is limited to 60% of your AGI. This 60% limit does not apply to noncash charitable contributions.
- If you make noncash contributions to qualified organizations, your deduction is generally limited to 50% of your AGI.
- If you contribute capital gain property (such as appreciated stock) to a qualified organization, your deduction is generally limited to 30% of your AGI.
- If you make a cash contribution to a private family foundation, your deduction is generally limited to 30% of your AGI.
- If you make a contribution of capital gain property (such as appreciated stock) to a private family foundation, your deduction is generally limited to 20% of your AGI.
Contributions that exceed the limitation percentage in the year of the gift may be carried over for five succeeding taxable years.
For 2020, the president signed the Coronavirus Aid, Relief, and Economic Security (CARES) Act which changed the limitations that apply to cash contributions paid in 2020 to 100% of AGI. The contribution must be made in the calendar year and the taxpayer must make an election to apply this provision. However, this provision does not include contributions to private family foundations or donor advised funds.
Tax Savings Strategy
Assume taxpayer has a traditional IRA that has dropped in value during 2020 from $1 million to $500,000. This taxpayer is also charitably inclined and typically makes charitable contributions around $25,000 annually. If this taxpayer converted their traditional IRA of $500,000 to a ROTH IRA, it would cost them approximately $185,000 in additional tax on the conversion. If the taxpayer also simultaneously increased their annual charitable contributions by $100,000, it would cost the taxpayer approximately $157,000 in tax to convert the traditional IRA to a ROTH IRA. Some of the income tax generated on the IRA conversion is offset by the deduction obtained from the increase in the charitable contributions. When the ROTH IRA bounces back in market value, all the appreciation is now tax-free as well as all future earnings.
Assume a taxpayer decides to convert a portion of traditional IRA to a ROTH IRA. The taxpayer converts $100,000 of their IRA to a ROTH IRA while simultaneously increasing their charitable contributions by $100,000. There would be no additional tax to pay on the IRA conversion to a ROTH in this example. Although this example is extreme, it demonstrates the power of the combination of two strategies to save in overall income tax in the long run.
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