During the past few years there have been ongoing discussions in the media regarding the advisability of converting a traditional IRA into a ROTH IRA. In almost all cases the discussions have centered on the rules of when and how to make the conversion and how to calculate income tax. Luckily, there are several alternative approaches available to reduce income taxes, capital gains taxes and estate tax liabilities.
To best illustrate the ideal ROTH conversion, we can use a theoretical situation. Assume our client is pre-retirement age (64-years) and has a 67-year-old spouse. Their net worth amounts to $15 million with all assets of their combined estate, which includes a $4 million traditional IRA. In addition, they have an Irrevocable Life Insurance Trust (ILIT) that holds a $5 million survivorship life insurance policy funded and owned from outside of the estate for the benefit of their children. We also assume that the clients have charitable intent with their combined assets even though they do plan to leave a substantial portion of their estate to their three adult children. Their estate contains a $5 million commercial building, with a tax basis of $500,000 (due to two 1031 exchanges). The building is debt-free and is on a long-term lease to a Fortune 500 company. They are interested in selling the building, which generate an income of $250,000 annually, with this income taxed at ordinary income tax rate.
- Our clients’ income beneficiary ages are 64 and 67.
- The gift amount would be $5 million, based upon a proper real estate appraisal.
- Their cost basis is $500,000.
- Their payout rate will be five percent, based on their combined needs.
- As long as one client is alive, their payment schedule will be quarterly.
We would recommend our client change ownership of the commercial building to a Charitable Remainder Unitrust (CRT), with themselves named as the income beneficiaries and trustees of the CRT for their lifetimes. By entering these figures into a Planned Giving Calculator, the following results were provided.
- Our clients’ charitable deduction amounts to $1,729,800.
- Their first year income totals $250,000, with subsequent years’ incomes varying according to trust value.
- Their IRS discount rate would be 3.4 percent.
With this theoretical information, clients can begin the actual process of switching to a ROTH IRA from their traditional IRA with a better understanding of the income tax options available. You may also consider the following alternatives.
- Based on availability of a six-year deduction after the property is gifted to the CRT, a partial IRA conversion to Roth IRA may be applicable.
- Report the yearly total or partial conversion of the IRA– depending upon the amount of the charitable deduction available each year.
- When planning recognition of income and capital gains, the decision to convert can be adjusted yearly over the next five to six years to meet other planning needs.
Benefits of this plan:
- Clients have the ability to manage their own funds in the CRT once the sale of their property is completed or they sell a portion of the property inside the CRT.
- Tax on capital gains would be avoided upon sale of the real estate once inside the CRT.
- No loss in property value if there is a need to sell at the death of the owners.
- Ability to change charitable beneficiaries during their lifetime.
- Grantors of the CRT can benefit from current low IRS discount rates.
- Elimination of all estate taxes on property that is not held within the taxable estate.
Other types of property suitable for this type of transaction would include appreciated stock, bond, mutual fund, and managed accounts held for many years. The complete or partial sale of operating businesses may be considered for this strategy, especially in conjunction with the use of an Employee Stock Ownership Plan (ESOP), or a Charitable ESOP (CharESOP). It could also be used for royalty interests, as well as appreciated art works, that may be part of the client’s estate plan at death to bequeath assets to various charities.
Other solutions provided to the clients included the use of alternative investment vehicles, such as oil and gas programs to provide write-offs with unknown potential future income, tax credit programs, gifting over years (hard to accomplish with such a large asset), family limited partnerships to reduce the building value in the estate, and partial sales of the property to other family members. All of these suggestions had various negative consequences, and did not pique the interest or meet the objectives of the clients.
Financial advisors should consider the multitude of tax benefits appreciated assets can provide to achieve better results for clients. Each situation requires proper tax advice along with legal assistance.
William M. Upson CLU, ChFC
Upson is a financial advisor and a registered representative of Royal Alliance, offering securities through Royal Alliance Associates Inc. and is insurance licensed. He is a 17-year member of the Million Dollar Round Table (MDRT) with, 15 Court of the Table and 13 Top of the Table qualifications. Upson specializes in income and estate tax planning for high net worth individuals, successful professionals, business owners and retirees. He is also the author of “Long Term Care…Alternatives and Solutions,” and co-author of “Pathways to Financial Freedom for Everyone.”