The Ultimate Tax Planning Strategy- Combining Roth Conversions with Other Deductions

Our topic on this episode of the Ready for Retirement podcast is about creating the ultimate tax planning strategy – combining Roth Conversions with Other Deductions.

Questions answered: When should I do a Roth Conversion? How do I know which deductions I should take advantage of? How could a Donor-Advised Fund help reduce my taxes? Can I gift stock to my Donor-Advised Fund? What is the best approach for my individual situation? 

Are you ready to start focusing on the things that truly matter when it comes to your financial future?

Key Points

• Roth Conversion Example
  • Let’s look at an example: A husband and wife retire at age 60 and spend $100,000/year throughout retirement.
    • $1,000,000 in Cash.
    • $2,000,000 in IRAs.
    • $1,000,000 in Brokerage Account.
      • Let’s assume $10,000 of $100,000 is dedicated for giving.
      • Let’s assume they’re retired, with no mortgage.
• Charitable Giving
  • In this example, if this couple is retired and have no mortgage, they’re likely not receiving a tax deduction for giving. 
  • Most likely, this couple is taking the standard deduction of $25,100 because there isn’t enough mortgage interest, charitable giving, state taxes, etc. that would be higher than the standard deduction.
• Perspective – Charitable Giving
  • Example: If this couple gives $10,000 for 30 years, they’ve given $300,000 to charity and haven’t deducted anything. 
    • This is treated as an expense, not a deduction.
• Further Assumptions
  • Let’s assume this couple lives off of cash and Social Security for the next 12 years so they don’t have to pay taxes on IRA withdrawals.
    • Not withdrawing from an IRA today may seem like a good idea, but you will likely be paying a much higher tax bill in the future when RMDs (Required Minimum Distributions) begin.
  • If this couple has $2,000,000 in their IRA and it grows by 7%/year, it will be around ~$4,500,00 by the time RMDs start at age 72.
    • The required minimum distribution will be $175,000 at age 72.
    • By age 80, the required minimum distribution would be $240,000 at age 80.
  • If this couple only needs $100,000/year to meet their annual expenses, they would now be paying significantly more in taxes than they need to, and want to!
• Strategies to Reduce Taxes
  • Roth Conversions
    • There’s only so much a couple can convert before jumping into a high tax bracket, so what can you do if you want to reduce your tax liability in the future?
  • Donor Advised Fund
    • What if there was a way to take advantage of the next 30 years of giving that a couple is going to do so that it’s not an expense, but a deduction?
      • The couple can still give $10,000/year
    • What if this couple set aside $300,000 of Cash from their $1,000,000 and contributed the $300,000 in the Donor-Advised Fund today?
      • This is an irrevocable gift – once given to Donor Advised Fund, you can no longer give it back; it must go to a charity.
    • Instead of receiving no deduction for 30 years of charitable giving, this couple could take a $300,000 deduction, but first, we must create income.
      • How can we create income for a couple that is retired and doesn’t wish to go back to work?
    • This is where a Roth Conversion makes sense.
    • Let’s assume in the same year you contribute $300,000 to a DAF (Donor-Advised Fund), you do a Roth Conversion from your IRA into your Roth IRA.
      1. If you have $2,000,000 in your IRA and use $300,000 for a Roth Conversion, that’s 15% of your total IRA balance.
      2. 15% is now in your Roth IRA and the 85% is still in your IRA account.
      3. 15% of the growth of these funds are now in your Roth IRA account which will grow completely tax-free forever.
      4. $2,000,000 will have compounded and grown to $4,500,000, which means 15% of the growth is in Roth IRAs.
      5. $675,000 will now be in Roth IRAs at age 72 and $3,800,000 in traditional IRAs.
      6. In the previous example, there were $4,500,000 in IRAs before any Roth Conversions.
      7. With Roth Conversions, instead of a pre-tax portion of $4,500,000, there will be a pre-tax portion of $3,8000,000, which lowers the amount of taxes owed when Required Minimum Distributions begin. 
  • Important Details regarding Donor-Advised Fund
    • You can only deduct up to 60% of your adjusted gross income with a cash donation to your Donor-Advised Fund.
    • Example: If you donate $300,000 in cash to a Donor-Advised Fund, you can not write off the full $300,000.
      • You can only write off up to 60% of your adjusted gross income.
      • If you have no other taxable income, you can only deduct 60% of $300,000, which is $180,000 that can be deducted today which makes your adjusted gross income $120,000.
    • In this year you contributed, you would pay taxes on $120,000 instead of $300,000, which will save you a large amount in taxes because you’re paying taxes on a much lower base.
      • This is not assuming medical expenses, state taxes, which would lower your taxable income further. 
    • What about the remaining $120,000?
      • Any amount you don’t use this year to contribute can be carried forward for 5 years.
      • This is known as a Carry Forward Deduction.
      • You can do Roth Conversions and be very strategic about how much you convert each year to keep income as low as possible.
      • It’s not out of the question to stay in a significantly lower tax bracket while converting 25% – 30% from your IRA to your Roth IRA.
  • Tax Savings
    • In this example, instead of having $4,500,000 at age 72, you may have $1,000,000 – $1,500,000 in your Roth IRA and $3,000,000 – $3,500,000 in your IRA, when doing strategic Roth Conversions.
    • Charitable Giving no longer needs to come from your cash flow of Cash, Brokerage Account, or IRAs.
      • You’ve pre-funded your Donor-Advised Fund to reap the tax benefits and you have the ability to invest in a Donor-Advised Fund.
      • If you were invested in a moderate portfolio in your Donor-Advised Fund and you gave $10,000 from age 60 to 90, your Donor-Advised Fund was growing tax free for you and you would have $632,000 leftover.
      • Yes – you would have more money at the end of retirement than when you began.
      • If you had $300,000 growing at 5%/year, that’s $15,000/year of growth/year. 
        • While you’re giving $10,000/year, your Donor-Advised Fund is growing tax-free and fully supporting your giving.
        • Your Donor-Advised Fund would leave a significant amount of funds leftover at age 90 that you could leave to the charity of your choice, or you could increase the amount of your charitable contributions throughout retirement. 
  • Donating Cash to a Donor-Advised Fund
    • Let’s assume that the $1,000,000 brokerage account of this couple holds Apple Stock. 
      • Let’s assume Apple Stock was purchased for $10,000 many years ago and it is now worth $100,000.
      • If this couple lived in CA and had a combined tax bracket of 25%, the $100,000 is only worth $77,500 to them because of the 25% taxes on the 90% of gains.
      • If you chose to put property, business interest, or stock with a low cost basis in your Donor-Advised Fund, you can take a deduction on the fair market value.
      • For example, this couple could choose to gift Apple Stock to their Donor-Advised Fund and receive a $100,000 deduction.
        • Taking the deductions and embedding the gains can be a great strategy.
        • Donating cash allows you to deduct 60% of your adjusted gross income, although you can carry forward the additional deduction for 5 years.
        • Donating stock allows you to deduct 30% and deciding how much to deduct is what you want to determine based on your income, tax bracket, and other planning considerations.
  • When doesn’t this make sense?
    • If giving isn’t part of your strategy, doing this is not going to save you a net amount of income.
  • Who does this make the most sense for?
    • If giving is part of your planning process, this can be an extremely effective planning tool – by using a Roth Conversion & Donor-Advised Fund in conjunction.

Timestamps

2:19  – Roth Conversion Example

4:10 – Managing Your Tax Bill

4:50 – RMDs & Tax Planning (Required Minimum Distributions)

5:45 – Tax Implications of Roth Conversions

6:45 – Donor-Advised Fund

7:48 – How to Use Giving To Minimize Taxes

11:02 – Roth Conversion Benefits Year-After-Year

14:36 – Using Your Giving Account To Grow Your Money

17:30 – Gifting Stock vs. Cash

19:42 – Aligning Your Investments With Your Financial Goals

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