If wealthy clients lack your enthusiasm for Roth conversions, planner Joe O. Luby III has some ideas that can help. It's not that they don't understand the benefits of converting money in a traditional individual retirement account or 401(k) to a Roth. They get it. But they also know converted funds are taxed as ordinary income, and they are loathe to write that check.
"That's the sticking point," Luby, owner of Jagen Investments LLC in Henderson, Nev., said in a recent webinar that offered a range of strategies for overcoming the tax objection.
One approach is to find deductions clients can use to offset the conversion income. Business owners might have net operating loss deductions either for 2010 or carried forward from prior years. Investors in oil and gas deals may have depreciation deductions, Luby said.
Philanthropic clients can time their gifts and hence their charitable deductions, bearing in mind that such deductions are limited to a percentage of adjusted gross income based on the type of gift involved.
When talking with larger clients who give every year, Luby's advice is to do a charitable lead trust (CLT) today and accelerate deductions into the current year. This type of trust makes charitable payments each year until trust termination, when the remaining funds can pass to heirs. Tax-wise, the client's deduction for funding the trust can be engineered to the desired level and is leveraged by low current interest rates.
According to Luby, establishing a CLT with $500,000 now might yield a 2010 income tax deduction of $200,000 or more depending on such specifics as the trust term and payout to charity. "This is where you can really get creative," Luby said. "Every large conversion we've been involved with this year has included a charitable lead trust component."
Another approach involves utilizing tax credits to lower the client's overall IRS bill and dampen the tax hit from the conversion. As a family planning example, a client's adult child could use her $8,000 first-time homebuyer credit to offset the tax on a $32,000 Roth conversion if she is in the 25% federal bracket, Luby noted.
Clients whose IRAs hold interests in private limited partnerships or limited liability companies may be able to take advantage of valuation adjustments. Suppose the client's minority share of the entity's net asset value is $1 million. After applying discounts for lack of control and non-marketability, a qualified appraiser might conclude that the interest's fair market value--which is the amount taxed in a conversion--is $700,000.
"The difference between net asset value and fair market value at the time of conversion is never taxed," Luby said. "We've literally eliminated the taxes on $300,000."
Advisors can remind clients that a 2010 Roth conversion offers unique advantages. One is a potentially lower tax. Ordinary rates might rise after this year, and in 2013 the new 3.8% Medicare surtax, which could be triggered by a Roth conversion, hits joint filers with incomes greater than $250,000 (and singles who exceed $200,000). Additionally, instead of adding the conversion to 2010 income, the client can add half in 2011 and half in 2012, and has until Oct. 17, 2011--the extended due date for 2010 returns--to decide.