If a Roth conversion is appropriate for your client, there are two options with regard to recognition of Roth IRA conversion income:
1) Elect to recognize 100% of the fair market value on the date of conversion as income in 2010 and pay tax at the current tax rates, or
2) Taxpayers can convert in 2010 and defer the recognition of the income until 2011 (50%) and 2012 (50%).
When determining which option is best for your client it is important to note that if the client decides to defer the income recognition until 2011 and 2012 they will pay taxes based on the rates in effect at that time.
There are many other factors to consider in determining if a Roth conversion is right for a particular client. However, consideration of a conversion should be part of everyone's year-end planning process.
2. Make charitable contributions. One strategy for dealing with that hefty tax bill (including the tax on a Roth IRA conversion) is to reduce the tax liability by making charitable contributions. Cash contributions to donor-advised funds (DAF) and public charities are deductible up to 50% of AGI, or 30% of AGI when donating to private foundations.
Contributions of securities or real property held long term that has appreciated in value can provide even better tax benefits. While the deduction is limited to 30% of AGI when donating to a public charity or DAF, and 20% when donating to a private foundation, your client can receive a charitable deduction for the full fair market value of the assets, not just what they paid for them. They will also eliminate capital gains tax that would otherwise be due on a sale.
Charitable contributions, of course, have the dual advantage of reducing taxes and helping your clients achieve their philanthropic goals.
3. Gift assets. The federal estate tax was eliminated for 2010, although heirs will not be able to take a step-up in basis for assets they inherit this year. Next year, if Congress takes no action, assets will be subject to a federal estate tax of up to 55%, with an exemption on the first $1 million in assets. Add in a 5% federal surtax and a 16% Massachusetts rate, and estate taxes may total as much as 76% of asset value!
Death is an unattractive alternative even when it provides a considerable tax benefit, but there are other ways to take advantage of this year's tax rates. One is to suggest that clients gift some of their assets to heirs this year. Taxpayers can gift assets valued up to $13,000 ($26,000 for married couples) to as many people as they want annually without subjecting themselves to the gift tax. In addition, each taxpayer is allowed a lifetime gift exemption of $1 million.
Your clients can leverage their gifts by giving away assets expected to increase in value, such as stocks that have recently fallen in value. They can also gift stock in their business at a discount; if they are gifting minority shares of their company, the stock is worth less than whatever percentage of ownership in their company it represents, because it is not a controlling interest.
They can also gift unlimited assets and pay the gift tax at the current rate, which is equal to the top federal income tax rate of 35%. Next year, if no action is taken, the gift tax rate will be the same as the estate tax rate, with a top rate of 55%.
Grandparents should also be aware that they can make gifts to grandchildren this year without paying a generation-skipping transfer (GST) tax. The GST tax is scheduled to return in 2011 at the same rate as the estate tax, but with a $1 million lifetime exemption. While gifts are exempt from the GST tax this year, gift tax rules still apply.