Conversion of Traditional IRA to Roth IRA – How to Deal with the Income Tax Consequences

For those taxpayers with a traditional IRA, for the balance of 2010, the government will allow you to convert an unlimited amount of your conventional IRA to a Roth IRA. A Roth IRA allows for withdrawals on an income tax-free basis.

Upon conversion, the taxpayer must recognize the income in the year of conversion (or elect to spread the income over 2010 and 2011). The taxpayer must also wait to receive distributions from the Roth IRA for a period of 5 years. Otherwise, a premature distribution from the Roth IRA will be subject to income tax and early withdrawal penalties.

Those taxpayers considering making the conversion and recognizing the income in doing so, would be wise to consider the old Charitable Lead Annuity Trust (CLAT) as a means to mitigating the income tax impact for the tax year ended 2010.

A CLAT is an irrevocable trust in which a qualifying charity receives an annual annuity payment from the trust for a minimum period ranging from 20 to 25 years, after which time, the balance of the trust’s assets are paid to the taxpayer’s children or other descendents.

With so many charitable and religious organizations facing tough economic times, the taxpayer making the Roth conversion may want to select one or more of those charitable organizations as a current annuity beneficiary, using tax dollars otherwise paid to Uncle Sam, and redirect them to their church or synagogue.

While it will not be possible to completely eliminate the tax liability caused by the Roth IRA conversion, the income tax savings from the CLAT will be directed to the named charity and one’s family. In effect, what is paid over to the charity are funds that would have otherwise been used to pay income and gift taxes.

To illustrate:

Senior has $4,000,000 in his IRA and immediately withdraws $3,000,000 for the Roth IRA conversion. The combined Federal and California income taxes on the $3,000,000 of income will be $1,366,500, leaving Senior with $1,633,500 for the Roth IRA. If Senior contributes $1,000,000 of those funds to the CLAT, Senior can take a $1,000,000 charitable income tax deduction, reducing his income taxes on the IRA conversion, and thus have an additional $455,500 to invest in the Roth IRA. Furthermore, after the end of the CLAT term, there will be a significant amount in the CLAT that passes to his children, which can range from $700,000to $1,300,000.

Conclusion:

The use of the CLAT to create a current charitable income tax deduction for future amounts paid over to charity not only increases the amount that is left to invest in the IRA, but also provides a mechanism whereby one can leave funds to children free of all estate and gift taxes.

For more information about any of the information discussed in this Client Alert, or any other income or estate tax planning or asset protection planning assistance, please contact Jeffrey M. Verdon Law Group, LLP at jeff@jmvlaw.com or (949) 263-1133.