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Create a Tax Deduction and Re-characterize Your Traditional IRA to a ROTH: Case Study #2

Barry GoldwaterWritten By: Barry Goldwater in Newton, MA

This is the continuation of the financial priorities theme to my posting last week (Re-Characterizing a Traditional IRA to a Roth). This is a very important tax question for everyone moving into retirement; How can one use philanthropy to create a tax deduction and then use that tax deduction to re-characterize a traditional IRA to a ROTH IRA? Go back with me to last week and in summary: Selling Appreciated Land.

Husband and wife in their 70s have land valued at $900,000 and purchased for $300,000. $600,000 profit which is taxable at sale at capital gains rate and that tax number is $120,000. By gifting the land to Legacy Tree Foundation, when the LTF sells the land, because they are a 501c(3) charity, there is no capital gains tax on the sale. The gift of land to LTF kicks off a $345,000 tax deduction and an income stream of $45,000 for 20 years in the form of a gift annuity. The deduction re-characterizes the traditional IRA dollar for dollar (because of the rules on how much one can deduct in one year, there is a carry forward of the deduction to the next year if necessary). $345,000 Annuitized will give this couple a $23,500 income for life. In a ROTH, there is no tax. In a traditional IRA there would be a $5,700 tax. Live 10 years, and this couple has saved $57,000 in taxes not paid by converting to the ROTH.

Let’s get deeper into other aspects of this philanthropic strategy which I did not touch upon; Life Insurance, legacy planning and income planning.

$30,000 of the annual $45,000 gift annuity income will be used to fund a 2nd to die life insurance contract of $1 million replacing the land asset and turning an illiquid inheritance into a tax free cash gift to their heirs. By getting rid of the tax on the land, this couple created; an annual income stream, a tax deduction and the ability to buy a tax free asset as a replacement asset for the land.  We have leveraged one gift to charity into 3 component parts. Any strategy that can leverage your principal to create 2 income streams and a tax deduction needs to be looked at in a serious way.

Here is a second example of how you can use philanthropy to fund Financial Priorities. Selling appreciated securities to re-characterize a traditional IRA to a ROTH.

Dr. Richards and his wife, both in their mid-sixties, own $1 million in qualified IRA annuities and $3.5 million in a non-qualified securities portfolio. His current salary is $350,000/yr. and he plans on working 4 or 5 more years. They asked me to help them figure out how to re-characterize the qualified assets now via Roth conversions in order to maximize the non-taxable income they will eventually receive during his retirement years. They are not interested in life insurance because they believe their $1 million gift to each child is sufficient. However, the Richards do not want to pay additional taxes now. They are philanthropic, as Mrs. Richards serves on the board of several local charities.

Here is solution #2, selling appreciated stock:

  • Total Value of Assets Transferred $2,000,000
  • Tax Deduction Created with LegacyPlan $855,000
  • Roth Conversion Done This Year $ 350,000
  • Total New Taxable Income; $350,000 X 2 = $700,000
  • Less Tax Deduction (Up to 50% ) ($350,000)
  • Taxable Income AFTER Qualified Deduction; $350,000, same as annual salary
  • Potential Tax Savings @ 35% $299,250 on the $855,000 tax deduction
  • Annual Gift Annuity Income (20 yr. payout beginning in 5 yrs) $120,000
  • Total Taxes Saved over 20yrs $540,000
  • Carry-Forward Tax Deduction for Next Year $ 505,000, to convert more of their IRAs
  • Current charitable gift $60,000 to Mrs. Richards favorite charity.

Using the tax deduction, we re-characterize $855,000 of IRA assets dollar for dollar and it will take 3 full years to accomplish this because of how much of a tax deduction one can use in any given year. In this case, it is 50% of gross income. If Dr. Richard earns $350,000 a year, and he is converting $350,000 of IRA to a ROTH, his income is now increased to $700,000. He can only deduct 50% of this number, in our case $350,000.  I also suggested to the Richards that they re-characterize the other $145,000 IRA and pay the tax out of pocket, around $42,000 because a $1,000,000 deposit today into an indexed ROTH annuity will pay Dr. Richards when he is 71 years old, $90,700 of tax free income (tax savings @35% $31,745 per year X 20 yrs. = $634,900). Included is a well being rider which will double Dr. Richards income for 5 years if he cannot perform 2 of 6 activities of daily living. Dr. and Mrs. Richards will receive $120,000 per year for 20 years from the gift annuity and because this was non IRA money used for the gift, each year there is a reducing tax on this income as well. It is called the “exclusion ratio” and money excluded from the tax formula is not taxed.

Their combined social security is $60,000 per year.  In summary, at 71 years old, the Richards will have a $270,000 per year income from the $2 million gift for at least 20 years. $180,000 of the $270,000 is taxable. By converting the $1 million IRA to a ROTH, the $90,700 annual income is not included in their taxable income.  If it were, it would have propelled the Richards into a new tax bracket with new sets of taxes, like the 3.8% tax on incomes over $250,000. This aspect of this strategy saves the Richards over $40,000 per year in taxes.

This philanthropic approach is the average person’s Charitable Remainder Trust. You do not have to be wealthy to take advantage of the tax laws and leverage. You just have to be creative with your financial priorities.

About the Author: Barry Goldwater is an insurance consultant specializing in tax deductible, income, and estate planning strategies. He can be reached at 617-527-9736 or barry@frg-creative.com.

To see more educational articles from Barry, click on the following link (Barry Goldwater).

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LegacyTree Foundation is a 501C3 non profit organization est. 1999. The charitable transactions outlined are tested and performed according to IRS code and they are not considered investments. LTF and Barry Goldwater do not give legal, financial nor tax advise.  All the deferred annuities mentioned and incomes derived through the Legacy Plans are deferred annuities underwritten by an investment grade insurance company and not LTF. All life insurance contract illustrations provided by investment grade life insurance companies.
Annuity123 is an educational platform only.  Annuity123 does not offer insurance, investment, or tax advice.  You should always seek the guidance of qualified and licensed professionals concerning insurance, investment, or tax matters.

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