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The editors of Fidelity Interactive Content Services (FICS) selected this content because it offers valuable information for investors.

Tax-savvy Roth IRA conversions

Before you convert your traditional IRA to a Roth IRA, consider two tax-savvy strategies.

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The benefits of a Roth IRA are clear—the potential for tax-free growth and tax-free withdrawals for you and your heirs.1

While not everyone may be able to contribute to a Roth IRA, most people can convert to a Roth IRA, as long as they have eligible money. And many do. In fact, Roth IRA conversions at Fidelity are up 12% this year over last year.

First, the basics

There are IRS-imposed income restrictions on contributions to a Roth IRA. In 2013, it's up to $112,000 for single filers for a full contribution and $112,000 to $127,000 for a partial contribution. It's up to $178,000 for joint filers for a full contribution and $178,000 to $188,000 for a partial contribution. These income restrictions do not apply to Roth IRA conversions, though. The restriction on a Roth IRA conversion is that you can convert only existing money in a traditional IRA or other tax-deferred retirement savings account.

Also, keep in mind that a Roth IRA conversion has a cost. You need to be prepared to pay income taxes on the amount you convert. But, by doing this, you give that money the potential to grow tax free and ensure that you have tax-free withdrawals for you and your heirs. You “front-load” the taxes.

Here are two ways to help you manage that tax hit. One even lets you do some good by combining the conversion with a charitable deduction.

Spread the cost

A common way to manage taxes on a Roth IRA conversion is to spread the conversion over a few years. This will allow you to spread the tax bill too, and it may also prevent the income from the conversion from bumping you into a higher tax bracket.

Consider this hypothetical example: Imagine a married couple, the Mullens, who expect to file jointly with $96,400 in taxable income in 2013. They could convert up to $50,000 to a Roth IRA and stay within their 25% tax bracket (which for 2013 is taxable income between $72,501 and $146,400). As long as their tax rate and income generally stay the same, they could convert this amount yearly until they reach the total amount they want to convert. The potential benefit: They maintain a consistent tax rate when converting (provided their situation or the tax rates don’t change in the ensuing years). If they converted more than $50,000, amounts over the 25% marginal rate income range would be taxed at the 28% marginal rate. Things aren’t always as simple, however, as they are in this example. For higher-income filers, for instance, phaseouts on itemized deductions and personal exemptions can make computing taxable income more complex. 

There are also other things to consider. Your conversion must be completed by December 31. Estimating your taxable income may be tricky until you’ve received all your tax reporting documents, which typically aren’t available until well after December 31. So your income may end up being higher or lower than you expected.

A solution: a recharacterization. It allows you to “undo” some, or all, of a conversion made the prior year. You have until October 15 of the year following conversion to recharacterize.2 For example, say after they converted $50,000 to a Roth IRA, the Mullens discover in January 2014 that their income was higher than they expected in 2013. Because of that, $10,000 of the conversion ended up being taxed at the 28% rate instead of 25%. They could recharacterize that $10,000 to bring their amount back into the 25% bracket. A conversion completed in 2013 can be partially or fully “undone” until October 15, 2014. 

Some recharacterizations save more than others, and because they do involve paperwork, it’s a good idea to do the math and make an informed decision. For the Mullens, the recharacterization can save $300 because the tax rate to which they’ll be subject on the $10,000 in question is higher (28% vs. 25%) than anticipated. 

Another challenge: If you’re near the top of your bracket, it may take a long time to convert the total amount that you want without moving into a higher bracket. For instance, if you file jointly and your taxable income is $136,400 in 2013, you could convert only $10,000 if you wanted to stay within the 25% bracket.

Make a charitable contribution

Tax deductions can help offset the tax cost of a Roth IRA conversion and perhaps allow you to convert a larger amount at a lower tax cost. Among the more flexible of deductions, especially for high-income earners, are charitable contributions.

The tax deduction for a contribution to a public charity can be up to 50% of your adjusted gross income (AGI) for cash donations and up to 30% for donations of securities (generally deductible at fair market value when long-term appreciated securities are gifted) in a given year. And if your contribution exceeds these limits, the excess can generally be carried forward for up to five years.

To estimate the amount of the charitable deduction you may be able to claim, you generally add the taxable portions of your conversion amount to your AGI. For example, if you are planning to convert $200,000 to a Roth IRA and expect your AGI before the conversion to be $150,000, your estimated adjusted gross income (AGI) would be $350,000 after the conversion. You could potentially deduct up to $175,000 (50% of $350,000) of a charitable cash contribution, or $105,000 (30% of AGI) of a charitable donation of securities with long-term appreciation, which could significantly reduce the tax impact of a conversion.3

Consider this hypothetical example (shown below): Richard and Ellen Nettle, 57 and 58, respectively, are considering a large Roth IRA conversion in 2013. They have $270,000 in an eligible rollover IRA and $400,000 in a taxable brokerage account—which could be used to pay the taxes on the conversion, or to make a charitable donation. The Nettles estimate that their total taxable income before the conversion will be $180,000 in 2013. As a sales executive, Richard is concerned that in the coming years his income will be higher, pushing them into a higher tax bracket, so they’d like to convert as much of their rollover IRA at the lowest possible tax cost as soon as possible. The Nettles regularly give to charity and could make a $90,000 one-time gift to charity this year from their taxable brokerage account.

As the chart above shows, the Nettles' total estimated tax cost for a conversion in 2013 would be $30,733 less if they make a charitable donation the same year they convert. However, they would need to be able to afford the $90,000 charitable donation—an important consideration. On the other hand, if the $90,000 that the Nettles gave to charity included securities with long-term appreciation, by gifting them they also avoid taxes on the realization of those gains.4 In some cases, that can significantly reduce the effective after-tax cost of a charitable contribution.

One note: Our hypothetical example only includes current federal taxes. State and local taxes could also have a significant impact. And a higher AGI may limit or reduce other deductions as well. For these reasons, it’s important to speak with a tax adviser as part of a Roth IRA conversion decision.

Let’s look at some smaller numbers. For example, assume that your taxable income was $72,500 (which is the top of the 15% bracket for joint filers in 2013) before a Roth IRA conversion. If you combined a charitable gift of $20,000 with a $50,000 taxable Roth conversion amount and the assumptions above, then only $30,000 of the conversion amount would be in the 25% tax bracket rather than the full $50,000. That would result in a tax savings of $5,000 (25% of the $20,000 charitable deduction) compared to not making any charitable donation. Of course you would need to be able to afford the $20,000 charitable donation to save that $5,000.

What if you prefer giving regularly rather than making a single large gift to charity when you convert to a Roth IRA? You may want to consider a donor-advised fund, or DAF. DAFs which are programs offered by public charities, allow you to make a charitable contribution in a given year, and take a tax deduction for that year. Then, at a later time, you can recommend grants from your DAF to the charities you wish to support. You could take a tax deduction in the year you do a Roth conversion to help offset the conversion taxes and still continue supporting charities over several years. With a DAF, you front load a “ready reserve” of charitable dollars that can be used over time to support many charitable causes.

Some challenges to the charitable-offset strategy: Gifts to charity are irrevocable. Unlike Roth conversions, which can be “undone,” or recharacterized, gifts to a charitable organization, including DAFs, are final. So if you decide to recharacterize, you would need to determine how much of your charitable donation was deductible for that year and how much may need to be carried forward to other years. It also might be at a lower tax bracket than you expected. Also, charitable deductions may be worth more if taxes go up in the future, because they may be deducted against a higher tax rate. 

Conclusion

Managing the tax impact of a Roth IRA conversion requires careful analysis. Ideally, you should include it as part of a review with a financial or tax adviser to fully investigate whether you’re likely to benefit from a Roth IRA conversion and how to execute it appropriately.

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1. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, die, become disabled, or make a qualified first-time home purchase.
2. To be eligible to recharacterize, you must file your taxes or an extension by the April 15 deadline.
3. This does not take into account any limitations on itemized deductions or personal exemptions for taxpayers in higher tax brackets.
4. The 50% limit on cash contributions and 30% limit on security contributions to 501(c)3 public charities is an aggregate limit as a percentage of a taxpayer’s adjusted gross income (AGI). Gifts to charity are irrevocable and nonrefundable.
Information provided is general and educational in nature. It is not intended to be, and should not be construed as, legal or tax advice. Fidelity does not provide legal or tax advice. Content provided relates to taxation at the federal level only. Availability of certain federal income tax deductions may depend on whether you itemize deductions. Rules and regulations regarding tax deductions for charitable giving vary at the state level, and laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of the information provided. Charitable contributions of capital gain property held for more than one year are usually deductible at fair market value. Deductions for capital gain property held for one year or less are usually limited to cost basis. Consult an attorney or tax adviser regarding your specific legal or tax situation.
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