This Roth Strategy Leads the Way

The virtues of Roth IRA conversions are well known. For the money moved from a traditional IRA to a Roth IRA, there will be no required minimum distributions. Roth IRA owners will owe no tax on withdrawn earnings after five years and age 591/2. That said, Roth IRA conversions typically come with a steep price: ordinary income tax paid at the account owner’s top tax rate, perhaps long before any tax is due.

Is it possible to execute Roth IRA conversions, yet owe little or no tax? Yes, for investors who are charitably inclined. They can combine Roth IRA conversions with an offsetting charitable lead annuity trust (CLAT). If a CLAT

is created in the same calendar year as the Roth IRA conversion, with the CLAT funded by non-retirement account assets, the resulting Schedule A itemized deduction could minimize or totally shelter the tax on the conversion.

Give-and-Take Back

A CLAT is an irrevocable trust that promises to pay a guaranteed amount to a charity for a specified period of time. When that period of time has ended, the trust dissolves and any remaining trust assets can revert back to the trust creator, or trustor.

A CLAT is an irrevocable trust that promises to pay a guaranteed amount to a charity for a specified period of time.

A CLAT is an annuity trust because a fixed dollar amount is paid from the trust to the designated charity each year of the specified payout term. During that time the CLAT’s assets are invested, often in securities selected by the trust creator’s advisor.

From the trust term and the annual donation amount, the present value of that future income stream can be calculated and taken as an upfront tax deduction. Indeed, money guaranteed to be paid out to a charity from a properly drafted and funded CLAT can create a substantial one-time itemized deduction on Schedule A of the trustor’s tax return for the year that the trust is created and funded, offsetting the increase of taxable income caused by the Roth conversion.

Thus, a CLAT can be designed so that the taxable amount that is converted from a traditional IRA to a Roth IRA will be the same as the allowable charitable contribution. If the amounts cancel out, the result can be a tax-free Roth IRA conversion.

Thus, a CLAT can be designed so that the taxable amount that is converted from a traditional IRA to a Roth IRA will be the same as the allowable charitable contribution.

Drilling Down

Example 1: To see how a CLAT might work, suppose a hypothetical Jim places $100,000 of after-tax money into a newly created CLAT that provides for a 7% payout to his alma mater for a period of seven years. This results in a present value (PV) calculation of approximately $40,000, at an assumed Applicable Federal Rate (AFR) of approximately 5% for the $49,000 guaranteed irrevocable donation of $7,000 for seven years.

Jim can deduct the $40,000 PV amount on Schedule A of his tax return for the year of the CLAT’s creation. This allows Jim to execute a $40,000 Roth IRA conversion that is effectively tax-free in the same year.

Assume the language of the CLAT further stipulates that it will dissolve after seven years, at which point any remaining trust assets will revert back to Jim. If the CLAT’s investments hypothetically earn 7% after advisory fees, and the trust pays out 7% to Jim’s alma mater, it is possible that the full

$100,000 will revert back to Jim when the CLAT terminates.

Win-Win-Win-Win

In Example 1, assuming a 7% after-fees total average investment return on the CLAT assets, a series of CLATs created and funded with $100,000 each year for 10 years would accomplish the following:

Qualify for a charitable deduction of about $40,000 on Jim’s Schedule A each year for 10 years, as each CLAT is created and funded. The amount of the annual tax deduction would be lower if the AFR increases and higher if the AFR decreases.
Donate $7,000 to Jim’s alma mater each year for seven years — for all 10 years of CLAT creation. Altogether, $490,000 ($49,000 times 10) would go to the school.
Convert $40,000 of traditional IRA money to Roth IRAs each year for 10 years. That would move a total of $400,000 from pre-tax traditional IRAs to after-tax Roth IRAs, all tax-free. Taxable RMDs would be reduced and so would the risk of owing steeper premiums for Medicare Parts B & D.
Regain for Jim the $1,000,000 used to create multiple CLATs, if the money is invested well. Each year for 10 years, the $100,000 used to fund a CLAT could possibly revert back to Jim, to use as he wishes.

Proceed with Caution

A potential downside to this approach may appear if a grantor trust is used for the CLAT. This term is used to describe any trust over which the grantor or other owner retains the power to control or direct the trust's income or assets.

Consequently, if the CLAT is a grantor trust, it will use the creator’s Social Security number. Any capital gains or interest income or dividends occurring in the CLAT-owned investment account must be reported on the creator’s tax return, generating a tax obligation. In practice, though, the amount of tax owed on those dividends and capital gains generally will be minimal, compared to the tax on future distributions from a traditional IRA without a Roth conversion. Also keep in mind that current taxes on CLAT income should not be a major deterrent to this strategy, because the assets that will be invested in the CLAT account likely would have created taxable interest, dividends and capital gains in the investment account or accounts holding the assets before they were moved into the CLAT.

An additional concern from a grantor trust structure is that the charitable deduction allowed from a CLAT is limited to 30%

of the creator’s adjusted gross income (AGI). Again, this may not be a huge problem because any unused charitable tax deduction from the CLAT is allowed to be carried forward on Schedule A for 5 additional years.

Because of the 5-year carry forward of unused charitable deductions (as stated, a charitable deduction for a CLAT is limited each year to 30% of that year’s AGI), the administrative headache of creating and administrating multiple trusts may be avoided by creating just one CLAT, funded with one large amount. Then the CLAT’s charitable contribution may be deducted annually for the next 5 years. This may work well as long as the 30%-of-AGI rule is properly anticipated.

Example 2: Suppose that Jim from Example 1 creates one CLAT, immediately funded with $1 million of non-IRA money. Although the terms of the trust could be set up differently to better meet the creator’s actual situation, let’s say this CLAT follows the same terms: it pays out 7% ($70,000) to Jim’s alma mater each year for 7 years, then dissolves.

The trust would be paying out $490,000 ($70,000 x 7 years) to the college. Assuming the same PV calculation, this would provide a $400,000 charitable deduction, subject to the 30%-of-AGI limitation each year. The charitable gift deduction can be taken each year for 6 years (the year the trust is created and funded, plus 5 additional years of carrying the deductions forward.) Backing into the math, $400,000 spread over 6 years is $66,667 deducted each year on Schedule A, as a charitable contribution. An AGI of at least

$222,222 would be needed each year to allow the full $66,667 deduction (30% of $222,220 is $66,667).

This plan would allow for Roth IRA conversions of $66,667, each year. If played out for the full 6-year deduction spread, then $400,000 ($66,667 x 6) could be converted from the pre-tax IRA accounts to the Roth IRA account …all tax-free.

In proactive, longer-term tax planning, it is helpful to remember that the annual projected AGI will include the amount of the taxable income that results from the Roth IRA conversion. Doing the math beforehand with viable projections will allow the CLAT creator to maximize this strategy.

Keep in mind that a CLAT is irrevocable: the creator cannot ask for the money back before trust termination or change charitable beneficiaries. That said, combining CLAT creation with Roth IRA conversion may provide a desirable mix of charitable fulfillment and long-term tax savings.

Advisor Action Plan

• Explain the advantages of Roth IRA conversions.

• If clients are wary of paying tax on these conversions, see if they have substantial charitable intent.

• Explain the advantages of CLATs to clients who express interest in philanthropy, and who have “extra/ uncommitted” non-IRA assets available to (temporarily) fund the CLAT.

• For suitable clients, seek the aid of a qualified estate attorney familiar with CLAT planning, drafting, and administration. Ideally, work with a board-certified specialist in estate planning who is familiar with creating and implementing CLAT strategies.

Throughout his 40-year career, Jerry Blakely has been a devoted financial advisor who has passionately assisted clients with their retirement planning needs for over four decades. Specializing in working with families on the brink of retirement or those already retired, Jerry has built a distinguished reputation for providing personalized recommendations aimed at preserving and growing wealth while mitigating tax liabilities. He is a CERTIFIED FINANCIAL PLANNER™ professional, and holds the CLU and ChFC designations as well. Jerry earned his bachelor's and master's degrees from California State University, Northridge.

Having recently retired from private practice, Jerry continues his passion for the Investment Advisory industry as the Director of Advisor Sales and Training with Householder Group Estate and Retirement Specialist, LLC, where he conducts Advisor Development Training and Coaching classes. Jerry has been a member of the Ed Slott Elite IRA Advisor GroupSM since 2014.

Reprinted from the July 2023 edition of the Ed Slott’s IRA Advisor newsletter.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Householder Group Estate and Retirement Specialists LLC. advisors are Registered Representatives with, and securities offered through LPL Financial, Member FINRA/SIPC.

Investment advice offered through Householder Group Estate and Retirement Specialists LLC., a Registered Investment Advisor and separate entity from LPL Financial.