Charitable Deduction to help for Roth Conversion or NUA?
Please respond only if you are an Ed Slott Advisor, a CPA or Attorney. This question is in 3 parts. Thank you.
Part I – At our November 2012 Ed Slott Advisor conference in AZ, Rau spoke (at a breakout session) of a strategy to help create a large charitable deduction to potentially help offset against income tax liability created from a large Roth Conversion. Does anyone remember what that was?
Part 2 – I am currenly facing a client situation where there is also a potentially beneficial NUA option with cost basis of $700K and account (stock) value of $1.5Million, all company stock. Therefore, she has has a viable option to do either a Roth IRA Conversion or NUA, prior to year end. Assuming she does need income from this asset, but only a modest amount on an annual basis, once either strategy is implemented, which strategy would you select and why (or why not)? Other ordinary income (married filing joint) is approximately $100,000. Other retirement assets total $2.5 million, other non qualified assets total $1mil. Assume we are getting this done by 2012, and the complete IRA account will be converted or distributed using NUA (for an apples to apples comparison). Clients are healthy, early 60s. Any opinion is welcome.
Part 3 – Does anyone have any thoughts on using a CRUT to help offset a the tax for either the Roth Conversion and/or NUA in the above scenario?
Thank you.
Permalink Submitted by mk foss on Mon, 2012-12-03 02:41
I can’t help you with Part I but I have some general comments about Part II and Part III. It’s possible to use more than one technique – for example, you could take some shares in an after tax account benefiting from NUA and do a Roth conversion for others. The downside is that the Roth conversion is taxed at the FMV of the shares converted and not at the plan cost of the NUA shares. A regular IRA rollover is another alternative for some of the shares as well.
The CRUT may be a great idea in this situation. NUA shares are the “highly appreciated assets” that we think of when establishing a CRUT. You’d have to run the numbers with their ages and the FMV of the shares but you may get a very nice charitable deduction along with an income stream for retirement. The downside of the CRUT occurs when there are children or other beneficiaries they want to benefit. The regular CRUT will disappear when the second spouse passes away.
I don’t think you should limit who you want to respond to your questions. Alan is the most knowledgeable and creative person that posts here and he doesn’t fit into your limited categories for responses.
Permalink Submitted by Christian Cordoba on Tue, 2012-12-04 08:20
Thank you very much for the response. Rethinking it, I would agree that leaving the response pool open makes more sense. Alan, or anyone else, I’m open to your feedback.
In particular I’m aware of the current tax consequences of Part 2, but looking for considerations or opinions on which people feel would be most advantageous in the long run given the current economic climate, and why.
Regarding Part 3 about the CRUT, the clients don’t have any kids, so I’ll explore this in more detail thank you. I’d be appreciative of any input anyone may have on viable resources to research and/or help the client implement a CRUT properly.
Again, thank you for the response.
Permalink Submitted by Bruce Steiner on Sat, 2012-12-08 22:53
As regular readers of this group know, I’m a lawyer.
A forum such as this can be useful for providing general information, but not specific advice, since we don’t know all of the facts, or your client’s objectives. If you need or want help on this matter, I suggest you bring in co-counsel.
A charitable remainder trust (CRT) provides “income” to one or more individuals for life or a term not to exceed 20 years, after which the trust ends and the remaining trust assets go to charity. Since the trust is tax-exempt, the principal advantage is that it permits the client to sell the appreciated asset and diversify, while deferring the capital gain. On the other hand, (i) it defers rather than eliminates the capital gain, (ii) the capital gains will be taxable to the clients at the rates in effect from time to time, which may be higher than this year’s rates, (iii) the present value of the charity’s remainder interest must be at least 10% of the initial value of the trust, and (iv) you give up a good deal of flexibility. We did many more CRTs when capital gains were taxable at 28% than we’ve done since the capital gains tax rate was reduced to 15%. If the capital gains tax rate is increased, we may begin doing more CRTs.
There is also an income tax deduction for the present value of the charity’s remainder interest, but that’s secondary, and is not what drives the CRT.
In this case, NUA is less attractive than it might be since over 40% of the value would be currently taxable as ordinary income.
Roth conversions are generally beneficial. However, in this case, since they have $4 million of retirement benefits and $1 million of nonretirement assets, they don’t have enough nonretirement assets to pay the tax on the conversion if they were to convert all of their retirement benefits. Since their income is modest, they might want to consider converting a portion of their IRAs each year, so as not to be in too high a bracket in any one year.
Permalink Submitted by Christian Cordoba on Sun, 2012-12-09 03:40
This is perhaps the best explanation I have read on how to consider the application of a CRT and I appreciate it very much. I didn’t realize the capital gain still gets deferred (must have missed that in the financial planning classes), so that is something I have to research more on my own to learn how and when the gain is applied. My guess at this point is that it is paid proportionately upon the client receiving the income from the CRT, at the then current tax rates for the year the income is received.
Since my initial reason for considering this strategy as an option was to help create a deduction to offset the large tax liability from either a large Roth Conversion or NUA distribution, during a period we assume to be lower current lower tax rates, the deferral of the taxable capital gain is a significant factor. Again, thank you. I suppose there is no magic bullet and perhaps a simple charitable contribution may be ofsome assistance, but as you suggested I’ll seek local counsel for some of these tax/legal considerations. Unfortunately, I have not yet met someone I have confidence in to provide this type of advice in a competent manner, which is why I posed the question and scenario here first. The additional knowledge here will help me have a better collaboration with a local financial practitioner on behalf of the client. But I’m open to any resource someone may have for finding a local reliable advisor in this capacity if anyone knows of one…in addition to Ed Slott Advisors. I’m assuming a tax attorney would be most likely to refer this type of case? Again, thank you both very much for the responses thus far.
Permalink Submitted by Alan Spross on Sun, 2012-12-09 04:10
Remember that NUA is not an all or nothing option. With your NUA cost basis as high as it is, it might be to your advantage to determine an ideal % of the shares to be transferred to a taxable brokerage account. While the vast majority of plans uas an average cost basis for the employer shares, there are a few plans that account for different cost basis for different lots of company shares. In that case, you could elect the lowest cost basis shares for NUA, and roll over the rest.
Further, if there is any “plan basis” (as opposed to NUA cost basis) in the plan from after tax contributions that can be attributed to the employer shares, it will reduce the taxable cost basis when the NUA shares are distributed. And if your “plan basis” is a higher % than your IRA basis, you can directly roll from the plan to a Roth IRA, with some of the Roth rollover attributed to basis being tax free. Obviously, you can also split any rollovers between Roth and TIRA direct rollovers, the portion not used for NUA can be split between the two IRA types.
Yet another strategy that can be useful in certain situations is isolating your basis if you have after tax contributions in the plan. In PLRs 8538062 and 2002-02078 the IRS approved applying the pre tax amount of the plan to a rollover to an IRA (TIRA or also Roth) and applying the basis to the amount of shares you opt to use for NUA. These letter rulings are based on Sec 402(c)(2) under which in a rollover the pre tax amounts are deemed rolled over first. This particular condition likely requires that the entire distribution be made to you and not done by direct rollover, but mandatory 20% withholding is not applicable to NUA shares.That would again reduce the taxation of the lump sum distribution. So if you have plan basis it results in many options to use to piece together to your advantage.
Regardless of the options elected here, the obvious pitfall is lack of diversification (Enron, Worldcom etc) so most of the shares should be sold sooner rather than later. For the NUA shares that means LT CG taxes, but possibly deferred as Bruce mentioned with respect to a CRT.
Permalink Submitted by Christian Cordoba on Sun, 2012-12-09 04:42
Thanks Alan,
I appreciate the comment. There are no after tax contributions on her 401(k), but there are on his. Unfortunately his does not have the appreciation in value to the basis that hers does, so we are working with her for the purpose of these questions. Nonetheless, the feedback is very helpful, thank you.
One thing I was considering since we are near year end and time is an limited on these important decisions, is doing the NUA prior to year end with the entire amount to close out the 401(k), then waiting until any tax change is announced (especially to capital gains rates) before deciding how much of the stock to sell this year verus next year – after collaboration with their tax advisor of course. Then after January 1st, since we are still within the 60 day period, we can determine based upon the taxable impact of the stock sale, how much to rollover to a T-IRA or convert to a Roth IRA at that time.
Any reason why this may not be a good idea?
Permalink Submitted by Bruce Steiner on Sun, 2012-12-09 13:14
PLR 8538062 is the classic ruling on allocating all of the basis to the shares not rolled over. However, it should be noted that the IRS ruled the other way in PLR 8426132, and that private letter rulings are not binding on the IRS except with respect to the taxpayers to whom they are issued.
Alan: thanks for mentioning PLR 200202078.
More recently, in PLR 201144040, while the IRS did not specifically rule on that issue, the taxpayer and the IRS both assumed that the entire basis would be allocated to the shares not rolled over. The taxpayer in PLR 201144040 privately told me that he (and presumably his lawyer) was not aware of the previous rulings, and simply assumed that he could allocate all of the basis to the shares not rolled over. I know that many taxpayers have taken that position based on PLR 8538062. However, I don’t know whether you could get a ruling on this issue today.
As previously noted, this forum is good for providing general information. However, without knowing the relevant facts, and your clients’ objectives, it’s impossible to provide specific advice. For example, you said that your clients don’t have any children. If they intend to leave their estates to charity, they wouldn’t do any Roth conversions at all. If they intend to leave their estates to their nieces and nephews, the task becomes how much to convert each year. There are, of course, other possibilities, such as leaving their traditional IRAs to charity to the extent necessary to eliminate any Federal estate tax and then leaving the estate tax exempt amount to their nieces and nephews.
Permalink Submitted by Alan Spross on Sun, 2012-12-09 16:52
[quote=”[email protected]“]Thanks Alan,
I appreciate the comment. There are no after tax contributions on her 401(k), but there are on his. Unfortunately his does not have the appreciation in value to the basis that hers does, so we are working with her for the purpose of these questions. Nonetheless, the feedback is very helpful, thank you.
One thing I was considering since we are near year end and time is an limited on these important decisions, is doing the NUA prior to year end with the entire amount to close out the 401(k), then waiting until any tax change is announced (especially to capital gains rates) before deciding how much of the stock to sell this year verus next year – after collaboration with their tax advisor of course. Then after January 1st, since we are still within the 60 day period, we can determine based upon the taxable impact of the stock sale, how much to rollover to a T-IRA or convert to a Roth IRA at that time.
Any reason why this may not be a good idea?[/quote]
That should work, as long as any rollovers are completed within 60 days of receipt of the distribution. The rollover of shares that are not used for NUA purposes is permitted, but it is vital to get the accounting right because if shares are sold under NUA rules, the proceeds of those shares are NOT eligible for rollover even though non NUA shares proceeds could be rolled over is a similar situation. The rollover rules from QRP distributions are explained on p 25 of Pub 590, but the NUA exception is not mentioned there. Therefore, the choices are:
1) Report the NUA cost basis and cap gains only if sold for the shares on which NUA is elected.
2) Roll over shares on which NUA is not elected and include an explanatory statement with the tax return because the end result will differ from the 1099R taxable amount and NUA figures.
It is getting rather late to execute a qualified LSD for NUA purposes. For a qualified LSD, all amounts in retirement plans of like kind MUST be distributed by 12/31. If there are any plans or amounts from trailing dividends left in the plan the LSD is not qualified and NUA is lost. Much worse, in most such cases the taxpayer will not find out about it until the 1099R is received and no NUA is included and by that time it is often too late to fall back on a rollover. I am not aware of specific PLRs that deal with this fallout. A DB plan is NOT considered a retirement plan of the same type, but ESOP and 401k plans ARE of the same type (profit sharing plans).
Finally, in doing a post 1/1 rollover, the 5498 issued by the IRA custodian will not be issued for another year, so the rollover will have to be fully explained to the IRS with the 1040.