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Roth IRA Conversion Puzzle a No-Brainer for Philanthropic Clients

The decision to convert from a traditional IRA to a Roth IRA in 2010 can seem dauntingly complex: Will clients be in a higher or lower tax bracket in future years? Will their heirs’ tax brackets be lower than the clients’ top rates?  Should clients spread tax on a 2010 conversion over 2011 and 2012 – when tax rates may have risen – or opt to report all taxable income in 2010?

All of these murky questions could be swept aside if it were possible to minimize the taxes resulting from a Roth conversion.  In fact, there may be a simple solution: If a client’s estate plan contains large charitable bequests, he or she could accelerate those bequests into 2010 gifts, exercise the option to report IRA conversion income in 2010, and use the charitable deduction to reduce or avoid income taxes.  Additionally, clients who have carried over excess charitable deductions from past years should be able to use up more of their carryovers, since Roth conversions magnify adjusted gross income.  Other donors might bunch four or five years’ worth of annual gifts into 2010, contribute to a donor advised fund or prepay multi-year charitable pledges.  Charitable remainder trust beneficiaries who feel they no longer need their CRT payments can secure large deductions by assigning income interests to charitable remaindermen.

What if clients feel they don’t have the cash flow to accelerate charitable bequests?  One strategy would be to deed part or all of a personal residence or farmland to charity, while reserving a life estate (see pages 2-7 and 2-8 of the Charitable Giving Tax Service).  Charitable deductions are currently unusually high for such arrangements, thanks to low Code §7520 rates. 

Suppose Maggie, age 65, has a lakeside vacation home worth $500,000 (the lot represents $100,000 of the total value).  She deeds the property to charity and keeps a life estate – and receives a charitable deduction in excess of $200,000 that reduces taxes on her 2010 Roth conversion.  Note:  Her deduction will be subject to a 30%-of-AGI ceiling, with a five-year carryover for any excess.  Alternatively she could deed a fractional undivided interest in the property to charity (50%, for example) and retain a life estate as to that portion (see the example on page 2-121, Charitable Giving Tax Service). At death, 50% of the property would pass to charity and 50% to beneficiaries named in her will. 

Deductions for remainder interests in farmland are substantially higher than those for personal residences, since depreciation is not taken into account.  Example: Farmer Jones, age 70, has 100 acres of pasture land worth $600,000 that he has included in his will as a bequest to charity.  If he “accelerates” that bequest into a lifetime gift of a remainder interest in the property, he can deduct $390,000, assuming a §7520 rate of 3.2%.   Jones can continue to farm the 100 acres or lease the land out to another farmer.

Another possibility is to make a gift that provides the donor with a large deduction and lifetime income as well, through a charitable gift annuity or charitable remainder trust.  Clients can enlarge their deductions by postponing the initial payment from a gift annuity for several years, or by choosing to receive payments from a charitable remainder trust for 10 or 15 years, rather than for life. 

Providing Flexibility in Charitable Bequests

Philanthropic clients may be unsure as to how much they can leave to charity and still preserve family security.   From an estate tax standpoint, no deduction will be allowed for a charitable bequest that is indefinite as to amount (for example, is discretionary with the decedent’s executor as to amount), since the amount actually passing to charity will be considered to have been transferred by someone other than the decedent.

In one case, a deduction was disallowed for amounts paid to charity by trustees of a decedent’s residuary trust where the decedent’s will provided:  “After my trustees have paid to Columbia Hospital the sum of not exceeding . . . $5,000 . . . I authorize and empower them whenever and as often as they are satisfied that they have in their hands ample funds . . . at their discretion and option, to pay any worthy charitable, religious or educational corporation, association or enterprise operating in the city of Milwaukee, Wisconsin, such sums of money . . . as they deem best . . .”  The court pointed out that the only absolute and mandatory bequest created by this language was a gift of one cent to Columbia Hospital, and that whatever else passed to charity from the trustees was transferred by them and not the decedent [Norris v. Comm’r., 43- 1 USTC ¶10,031 (CA-7, 1943)].

Several strategies come to mind for providing flexibility as to the amount of charitable bequests: bequeathing a percentage of the net estate, or a percentage of the residue to charity, enables the charitable bequest to rise or fall according to the success of the decedent’s investments, receipt of inheritances, etc.  Qualified disclaimers can also be employed to let family beneficiaries decide how much is appropriate to pass to qualified organizations. 

Choosing the Right §7520 Interest Rates

The §7520 interest rates used to calculate tax results for charitable remainder trusts and other “split interest gifts” have hovered in the low 3% range in recent months.  Clients who establish inter vivos gift arrangements can elect the most favorable rate from among three months: the month of the gift or either of the two prior months.  If donors elect a prior month, they must attach a statement to their tax returns declaring that an election is being made under Code §7520(a) to use a rate from a month other than the month of the gift, describe the interest being valued, provide the applicable valuation rate absent the election and inform the IRS of the month and rate chosen to value the gift [Reg. §1.7520-2(b)].  Which rate to elect?  Here are general guidelines:

Elect highest rate available
• Charitable remainder trusts (maximum remainder)  
• Charitable gift annuities (maximum deduction)
• Gift of remaining life estate by donor who previously contributed a remainder interest in a farm or personal residence

Elect lowest rate available
• Charitable lead trusts
• Gifts of income interests in trusts
• Gift annuity (maximum tax-free payment)
• Gifts of remainder interests in farms or personal residences

For a history of the monthly “applicable federal rates” dating back to 1989, click on “Monthly Interest Rates” in the table of contents of the Charitable Giving Tax Service.

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