Appendix C: Discounted Roth Conversions

In my opinion, pre-tax retirement accounts may be responsible for a giant leak in your wealth bucket. This leak takes years for you to become aware of and can become increasingly difficult to plug as your pre-tax accounts potentially grow over the years.

Anytime a decision is made to take action which necessitates an increase in taxable income, one must evaluate all possible measures to minimize or mitigate the resulting tax due.

Most CPAs—and many financial advisors, including certified financial planners (CFPs), investment advisors, and even tax attorneys typically view the Roth-conversion equation in a single dimension. How much did you convert, what will the tax be, and how long will it take for the tax-free growth to overcome the payment of taxes in the year of the conversion?

The problem with this single dimension viewpoint is it assumes you will have to pay tax on 100 percent of the Roth rollover amount and thus pay dollar for dollar the tax due. Both of these assumptions are wrong.

With respect to Financial Advisors, Warren Buffett has been quoted as saying “What makes them good is not their predictions, but their strategies for dealing with an uncertain future.” This could be no more true than in this single area of Roth conversions.

Roth Conversions—An Overview

Let’s review what the experts have been saying about Roth IRAs:

• “By allowing Roth IRAs, they also created the single most powerful estate-building and wealth-transfer vehicle available today. By not imposing RMDs on the owner, they gave the American taxpayer one of the greatest income tax ‘loop-holes’ in existence today.” (Douglas Warren, Roth IRA Notes for Advisors, Winter 2007)
• “The advantage of a Roth IRA over a regularly taxed account is obvious. Either way you pay income tax up front. But with Roth, you’re then done paying taxes; with a regular account you’re just getting started.” (Understanding the Roth IRA, Moneychimp.com)
• “The essence of a Roth IRA is that you pay tax on the seed, but reap the harvest tax-free.” (James Lange, Retire Secure! Pay Taxes Later. The Key to Making Your Money Last as Long as You Do, 2006, Wiley.)
• “The Roth IRA is the single best gift Congress has ever presented to the American taxpayer.” (Ed Slott, The Retirement Savings Time Bomb . . . And How to Defuse It, 2007, Penguin Books.)

On point with the above concept of “tax the seed, not the harvest” consider the following analogy:

Most folks know who Johnny Appleseed was. He was a man in the 1800s that planted thousands of apple trees, primarily in the Ohio region. What if the tax man said “Thanks Johnny, for all that you are doing to plant apple trees. Unfortunately, you have to pay tax on your activity. You have a choice. We’ll either tax your seeds now or you can wait and we’ll tax the harvest.” What would you choose? Let’s see how this choice applies to retirement strategies.

Here’s a hypothetical example. Let’s assume we have a 30 year old who has a qualified plan. He wants to put in $6,000 a year for the next 35 years. Let’s say his investments yield 8 percent per year and he’s in a 30 percent tax bracket. Basically, he’s going to save about $2,000 a year in taxes, right? So that means over 35 years he will have benefited from $70,000 dollars of tax benefits. Incidentally, $6,000 over 35 years at 8 percent comes to just about $1M. Now at the backend he says “This is pretty good, I’ve got my money in there, it grew, and I have $70,000 worth of tax benefits. But I’m afraid of running out of money so all I want to do is take the income off the top of this.” He’s still getting 8 percent, so that first year he takes out $80,000 per year. What do we know about that money? What we know is that it’s 100 percent taxable and if he’s still in that 30 percent tax bracket, that’s $24,000 of taxes.

What do we notice here? How long did it take the IRS to get back their money? It’s less than three years. They gave up $70,000 in tax benefits over 35 years and in less than three years they have it all back. If he lives 20 years longer and keeps drawing that $80,000, he’s going to end up paying an additional $480,000 in taxes. If it’s 30 years, it’s going to be $720,000 in taxes.

So let me ask you this: If the IRS thought enough to invest $70,000 in you, so they could get back between $480,000 and $720,000, would you invest $70,000 in yourself so that you could potentially keep that $480,000 and $720,000 for yourself or your heirs? If the answer is yes then you need to consider a Roth conversion sooner rather than later, and evaluate options that may offset and reduce the taxable income that results. This may be appropriate, whether you plan to use these dollars for retirement living expenses, or pass this wealth on to children and grandchildren.

Also, note that in our example he never spent any of his $1M. He only took the income off the top, so at his death that $1M will also be income taxed to his estate or beneficiaries. That would mean potentially hundreds of thousands more in additional taxes at his death.

You might be thinking “Wait! The income tax doesn’t have to be paid at death if he has children because you can do a stretch IRA.” If you’re not familiar with that, it simply means, from our example, that when he died, that $1M can be transferred to his children and they will take out distributions at that point over their lifetime. Sounds pretty good at first glance, doesn’t it?

Again, the IRS has done the math. If that really did occur and his child was 50 when it was inherited, there would be an additional $700,000 in taxes coming out during that child’s lifetime. So it’s almost $1.5M of taxes simply because it’s in IRAs or other qualified plans. So is it any question that the IRS loves qualified plans?

Roth IRA Fundamentals

With a Roth IRA, after-tax dollars are deposited or rolled over from an existing IRA or other retirement fund and all subsequent growth is tax-free based on current tax laws as of when this book was written. When you make the contributions to a Roth IRA those contributions are not tax deductible. The growth can be taken out tax free as long as you have remained in the Roth IRA for a period of at least five years and are above the age of 59½.

Taking out the growth of the Roth IRA before the five-year test will result in it being taxed at ordinary rates and if you pull out the potential growth before the age of 59½, you will be subject to a federal penalty of 10 percent on the withdrawn amount.

There are income tests which need to be met before an individual or couple filing jointly can contribute to a Roth IRA or roll over an existing retirement account or IRA to a Roth IRA.

In 2012 the Modified Adjusted Gross Income (MAGI) was $110,000 for a single individual and $169,000 for a couple filing jointly. These are the lower limits where you can contribute up to the maximum allowed, whereas if your MAGI increases, there are upper boundaries where you cannot make any contributions at all or use the IRA rollover.

These income levels change almost every year and there are exclusions to the withdrawal rules, so it is important to either look up the current levels or discuss with your financial adviser or CPA to see if you qualify.

In general, the younger the individual, the more beneficial a Roth conversion may be. That’s because there are more years available to recoup the taxes paid on the conversion. If it’s fairly early in the prospect’s retirement, longevity runs in the family, and the individual won’t need to access IRA assets for five years or more, a conversion may well be worth it because there is a higher likelihood of recouping the tax hit.

For those who are already retired and taking Social Security, converting to a Roth could potentially reduce the tax owed on Social Security income. Although the conversion could bump up the amount of Social Security benefits that are taxable in the year of the conversion, the conversion could potentially reduce taxes owed in subsequent years. That’s because Roth distributions don’t factor into the calculation that the IRS currently uses to determine which Social Security benefits are taxable.

Those who have primarily made nondeductible contributions in the past may be good candidates for a Roth conversion, because they won’t owe taxes on those nondeductible contributions—only investment earnings and deductible contributions will be taxed upon conversion.

Those who have amassed a large estate may want to look at an IRA conversion. Here’s why: (a) the Roth doesn’t require mandatory distributions, thereby allowing assets to potentially compound and increasing the amount which can be passed to a spouse or heirs; (b) because taxes have already been paid on Roth assets, the overall nest egg which can be passed to heirs will be smaller under the estate tax system, and therefore could help to reduce estate-tax liability.

Of course, the estate tax is another issue that will be changing one way or the other at the beginning of 2013, with the scheduled (and delayed) expiration of the Bush-era tax cuts.

Finally, for those who are unemployed or whose income is currently appreciably lower than it normally is, it might be advantageous to convert at this juncture. Provided that cash is available to pay the tax bill, taxes related to the conversion will be lower than they would be if the taxpayer’s income were higher.

Be careful, though—Roth IRA conversions make sense less often than is generally assumed.

What types of people are less likely to benefit from a Roth IRA conversion? Those who don’t have the money in other assets to pay the tax associated with the conversion, and those who know they’ll be in a significantly lower tax bracket in retirement should think twice about converting.

There are other issues you should consider when deciding if a Roth conversion is right for you.

The longer one lives, the more likely it is that a Roth IRA conversion will make sense, since the retiree will have potentially more years to enjoy the tax-free use of the Roth investment gains and, of course, more years over which to recover the tax paid on the conversion itself.

In all of the above situations, you should be aware that you needn’t convert all of your IRA accounts or even all of any single IRA account. Partial conversions are permissible, but you can’t pick and choose which IRA assets to convert. For example, although it would be advantageous, one can’t convert all of his or her nondeductible IRAs and leave the deductible IRAs intact. Instead, each dollar converted will receive exactly the same tax treatment based on the aggregate breakdown between deductible contributions/investment earnings and nondeductible contributions within the IRA(s).

Minimizing Taxes from a Roth IRA Conversion

Before I discuss potential ways to achieve this outcome, we must first ask the question “What will your income tax rate be in the future and how does it compare with your current rate?”

The higher your future tax rate, the more likely it is that a Roth conversion could potentially make sense. So let’s take a quick look at some of the issues that may influence future tax rates.

Now, here is a big question for all of us:

Will taxes in the future be higher?

The chart in Figure C.1 from Wikipedia 2011 may give us an indication—since the current 35 percent marginal tax rate is as low as it has ever been since the early part of the last century!

Figure C.1 Federal Top Marginal Tax Bracket Over the Last 100 Years

You probably won’t meet very many people who think that taxes will be getting lower anytime soon!

Historically speaking, tax rates are at extremely low levels now (2012).

We know that the folks in Washington have the power to change the rules, but each taxpayer has a right to use the current rules to try and achieve the best possible outcome—and when it comes to taxes, that means doing everything you can do legally in order to get the bill down as low as possible!

I believe that taxes as a percentage of gross domestic product (GDP) are destined to rise. But forget about the GDP—taxes as a percentage of your individual income are set to increase. And here is something to remember about THE IRS—if you don’t take a stewardship attitude towards reducing your income taxes to the lowest legal minimum, you are allowing more of your assets to become THEIRS!

Budget experts, including the non-partisan Congressional Budget Office, say that the deficit in future years is likely to be quite significant, even if deep spending cuts are enacted. If the spending cuts are not enough, where do you think the Federal Government will turn to stop our country’s “wealth leakage”? The only place they can turn to—taxes!

If I take a look at the fiscal condition of Social Security and Medicare, the news is not good. It appears that federal taxes will potentially need to be raised dramatically just to cover existing commitments to future recipients of those two programs, assuming that current health trends continue. To emphasize the point, federal income taxes for every taxpayer would have to rise in order to pay all of the benefits promised by these programs under current law over and above the payroll tax.

Raise taxes or break promises—what do you think Washington will do?

Probably both.

So if you believe that taxes are going to rise in the future, should you convert your IRA to a Roth IRA before rates go up?

Clearly, every individual situation is different, but there are many reasons why a Roth Conversion may represent the biggest long-term tax reduction strategy you may ever have the opportunity to utilize.

When it comes to this topic, what are the big issues? Evaluating Roth conversions is really a series of questions:

• Can I convert and How much should I convert?
• When to convert?
• How do I manage the taxes?
• What to invest in with Roth IRA money?

“Can I convert?” and “How much to convert?” are based upon an individual assessment of your financial specifics.

Having worked closely with clients on this topic since 2009, I can assure you that—just like snowflakes—no two individuals are alike.

“When to convert” has an easy answer if all the analysis of your particular situation indicates that conversion is a suitable strategy, then sooner rather than later is a good answer from one important perspective. If you convert, you have a “mulligan” or ability to have a “do-over” all the way to the date you file your return for the year the conversion is made. In other words, once you convert, you can still change your mind within some basic IRS rules. You can re-characterize all or part of the conversion, dialing in your final taxable income to exactly the right dollar amount desired.

This approach also buys you time to see how your investments within the ROTH IRA have performed.

Here is a good example of this approach—For an individual who was invested in U.S. equities, what month during 2009 would have been the best month to convert? The answer, with 20/20 hindsight, is March—when the equity markets were at the lowest point during the market decline. If an individual were to have converted at that time, their IRA would have probably been at its lowest point. A conversion based on that lowest value would have yielded the lowest tax on the conversion.

Let’s discuss a bit further the characteristics of taxes on IRA assets, before we look at ways of managing the taxes resulting from a Roth conversion. The above questions are all important, but before you try to answer any of these, there are two critical concepts to consider and understand.

Concept #1—Tax on an IRA Is Nothing More Than a Debt That Must Be Paid

What does the tax that is embedded within an IRA truly represent? It is a debt owed that must be paid. When you contributed to the IRA, or deferred income into your 401K, the tax you saved that year was not a gift, it was basically a loan.

Debt Free?

Many people approaching or in retirement consider themselves to be debt free. They have no car payments, home mortgage payments, or ongoing credit card debt.

Let’s look at a hypothetical example of this—Assume the following:

• IRA balances valued at $500,000
• Real estate valued at $500,000
• Non-IRA assets valued at $500,000
• No mortgage or traditional debt
• Marginal tax bracket at required minimum distributions beginning at age (70½) will be no less than 30 percent, due to other sources of income (Social Security, pensions, investment income)

Are they truly debt free? As this example suggests, you have a total net worth of $1.5M.

$500,000 IRA + $500,000 Real Estate + $500,000 Non-IRA = $1,500,000

If you were filling out a balance sheet for a lender, the liabilities section would have nothing but zeroes in it. But is this a true reflection of their financial position? Not really.

Consider the fact that the IRA balances were created from pre-tax contributions and tax-deferred growth over time. Thus, the tax saved each year you contributed is simply deferred. In essence, you have nothing more than a loan from the IRS that will be collected someday! The IRS is quite pleased to sit back and wait for the amount they are owed to grow. Very much like a “balloon payment” that cannot be refinanced away.

In this example, there is an embedded tax on the IRA balance—assuming a 30 percent marginal tax bracket—of approximately $150,000.

So your true net worth is not exactly $1.5M, it is only $1.35M or potentially less, depending on future tax rates.

What happens to this debt if you find yourself in a 40 percent tax bracket as a result of a future tax increases? The debt rises to $200,000!

An optimal outcome would be to find ways to reduce the impact of this tax debt coming due all at once.

Growing IRA Debt?

Money in a traditional IRA will continue to have a built-in embedded tax liability against the balance. As long as it exists, you don’t truly control it. If you don’t deal with it, it is a debt that will—intentionally or not—pass to your heirs. It is a debt that will increase over time, as a result of the potential growth of the asset. Worst of all, the amount of the debt can be increased at any time by the folks in Washington in the form of tax increases.

Just Pay the Tax?

In the preceding example, doing a Roth Conversion and paying the tax would reduce the total assets by $150,000 but at least you would be truly free of all debt in your retirement account.

But is there a better way to deal with the tax?

Change the Nature of the Debt!

Here is an outside the box idea. With mortgage rates being at historical lows, use a home mortgage—or a home equity line of credit—to free up the dead equity of the home, and use these funds to pay the tax on the IRA conversion.

You just have to decide which is most desirable—having a growing tax debt to the IRS, or a shrinking debt collateralized by other assets, whether that is mortgage on real estate, margin debt on investments, or other means of spreading out the payment of the tax. This allows you to take control of the debt versus letting the IRS and Federal Government dictate what you will owe in the future.

Whether you use an interest-only or an amortized loan on real estate, keep in mind that the IRS is subsidizing the financing of the tax used to unshackle the IRA by converting to a Roth IRA. The subsidy is in the form of mortgage interest deductions against personal income.

But if we just write a check—regardless of the source—and do nothing else, we might miss an opportunity to use the Roth Conversion in conjunction with other strategies to potentially realize a discount on the taxes paid.

Pattern of Debt Over Time

There are two types of debt, an increasing type and decreasing type as shown in Figure C.2.

Figure C.2 Two Types of Debt

The decreasing and amortized debt is, in my opinion, the most desirable to have on your balance sheet.

If you choose to transfer the debt which presently exists against the IRA, to one of the other assets, you have taken control over which debt pattern is potentially impacting your finances.

If a Roth Conversion makes sense for you, what is going to be easier—coming up with $150,000 out of after tax funds such as savings or investments in a single year, or making small payments between $8,000 and $13,000 per year over 15 to 30 years and have the IRS (based on current tax rules) subsidize the payments?

Said another way, you borrow against your home using a 15- or 30-year fixed-rate mortgage, pay the tax with the borrowed funds, and then slowly pay back the borrowed money via installment payments.

By spreading the IRA’s embedded tax cost out over a number of years, you take control of your tax outcome so that you can potentially use future tax reduction strategies to offset the future repayment of the tax debt—the debt that you transferred away from the IRA balance.

Unfortunately, when you consider the terms of the IRS loan on the deferred taxes on your retirement account, as described above, it is a very debilitating type of debt. Eliminating, or at least dealing with this debt on your own terms, is something that I believe must be evaluated.

Concept #2—Discounted Roth Conversions!

What other techniques exist to get a 35 percent, 30 percent, or even a 25 percent tax bill on a Roth Conversion potentially reduced to 15 percent or even 10 percent? That would represent a significant victory in protecting your retirement accounts from the ravages of the eventual tax bill.

In order to potentially achieve these lower effective tax rates on conversions, you must understand the concept of discounting asset valuations and how it could apply to potential Roth conversions.

Preliminary Measures

By putting a little thought into the process, you can optimize your tax outcomes, keeping two things in mind:

Additionally, don’t overlook opportunities to defer or delay the actual payment of the tax—effectively amortizing the cost over as many years as you may like. For example, if you have $100,000 of embedded tax within your traditional IRA, and you own your residence free and clear, you may want to do the math regarding taking out a mortgage against your residence, and using the proceeds to pay the tax. Presuming the use of a traditional mortgage with a 30-year amortization, you are locking down this single action of shifting the debt from your IRA to your residence, other real estate, or other assets effectively changes the tax debt on the IRA to a manageable debt on your terms, with the interest being deductible as well (under current tax law).

Effectively, if you are stretching out the payment of the tax, this creates opportunities to recapture or recover the taxes paid (repayment of the debt) over time through earnings on the $150,000 that was not used to pay the tax upfront.

Discounting Methodology

Discounting methodologies, which have historically been used with the transfer of entity interests (e.g., the gift or sale of the limited partner’s interest in a Family Limited Partnership, or FLP) during life or at death, adjusts the valuation of the assets or interests based on a lack of control, marketability, and liquidity. These discounts can range from 25 percent to 45 percent, subject to structure and asset characteristics.

In estate planning, this methodology is well established. IRS Revenue Ruling 59-60 lists relevant factors to be considered for valuing closely held corporations for estate and gift tax purposes, which include consideration for rights and privileges of stock ownership, as well as marketability of stock. Further, Revenue Ruling 68-609 approves the application of Rev. Rul. 59-60 factors in determining the fair market value of other business interests for income and other tax purposes.

The asset’s liquidation value is generally reduced by a discount that properly reflects fair market value (FMV) for federal income tax purposes.

Certain assets, when held in an IRA, can also generate substantial discounts. The result is a reduction of taxable income from a Roth IRA conversion. Correspondingly, the tax on the conversion is reduced, while the long term value of the asset is not diminished.

The application of this within an IRA is summed up in an August 2010 article “How to Enhance Roth Conversions” in Advisor Today Magazine, written by Joe Luby:

“Fair Market Value (FMV) must take into account the nature of the LLC or LLP units, including their illiquidity, lack of marketability and the fact that investors will generally hold minority interests in each fund. Thus a valuation adjustment may apply. In many cases, this adjustment may be from 25 percent to 35 percent from NAV. For example, a private fund with an NAV of $100 may be appraised at $70 for FMV purposes (adjustment discount of 30 percent).”

Please note—professional valuation of IRA assets is essential for this technique. Consult with your CPA, tax attorney, and other financial professionals for details.

Let’s look at an example, using two hypothetical brothers. Dave has an IRA valued at $1M, invested in stocks, mutual funds, and cash. The conversion to Roth generates a 1099R for the full fair market value (FMV) from the IRA custodian for $1M (see Figure C.3).

Figure C.3 Full FMV Assets

Assuming no other measures are implemented, in his combined 40 percent federal/state tax rate, Dave will owe a tax debt of $400,000 of income tax.

$1,000,000 × 40 percent combined Federal and State = $400,000

If Dave does NOT convert to Roth, and his IRA doubles in value in 10 years, then his tax debt will have grown to 40 percent of $2M, or $800,000.

Additionally, Dave’s portfolio is fully correlated to the equities markets, and for someone like Dave who is approaching retirement, tolerance for the level of market volatility will have to be very high.

Absent any planning to the contrary, Dave is not willing to bite the bullet today, so he does nothing. An unfortunate outcome, but considering a $400,000 tax bill, doing nothing is certainly understandable.

Let’s take a look at Dave’s brother Bob. Bob also has an IRA worth $1M, but he is invested in private and non-traded investments, such as REITs, Real Estate LPs, Equipment Leasing Trusts, Business Development Companies, and other Reg. D Royalty Funds.

An independent analysis by a qualified appraiser results in a Fair Market Value Estimate of the IRA at the time of the conversion of $700,000 (Figure C.4).

Figure C.4 Assets which May Qualify for IRS Value Discount

Thus, the income tax realized in the conversion is $280,000 ($700,000 × 40 percent combined federal and state income tax rate). Because his IRA assets were in illiquid investments, combined with an independent Estimate of Fair Market Value, the resulting tax savings is $120,000 over his brother Dave.

$400,000 (No discount tax bill) − $280,000 (Discounted tax bill) = $120,000 tax saved

Additionally, Bob’s assets within the Roth IRA are not correlated to the equities markets and should potentially have lower volatility in daily, weekly, or monthly changes in value that are common with the stock market.

Bob’s goal was to sleep well at night and not feel tied to the daily headlines swaying the equity markets and his retirement accounts.

Beyond the Discount—Offsetting the Income from a Roth Conversion

Let’s take a look at how additional planning, beyond the discount indicated above, can accomplish a significant reduction in the tax outcome.

After the asset level discount, reducing the IRA valuation down to $700,000, we are still left with a tax bill of $280,000.

Let’s evaluate the potential mechanisms in reducing the Roth conversion tax bill further.

• Offsetting the conversion income with Energy IDCs
• Offsetting the conversion income with Accelerated Charitable Contributions
• Offsetting the conversion income with Renewable Energy Tax Credits
• Offsetting the conversion income with participation in a Conservation Easement Partnership

Energy Intangible Drilling Costs (IDCs)

If a client is suitable for oil/gas drilling investments with their associated IDCs, they could consider making an investment using after-tax funds and use the corresponding tax deduction to offset the conversion income of a Roth IRA rollover. IDCs are typically 70 percent to 100 percent of the invested amount.

For instance a client with established suitability has a CD with $50,000 in it and he feels this money would be appropriate in an oil/gas drilling partnership with a corresponding 90 percent IDC deduction. He makes the investment and during the same year converts $45,000 of a separate IRA account to a Roth IRA.

The reportable income increase of $45,000 for the Roth IRA conversion will be offset by the $45,000 IDC deduction of the new oil/gas investment.

$50,000 oil/gas investment × 90 percent IDC = $45,000 self-employment loss(income tax deduction)

Alternative Minimum Tax levels apply and an investor looking to make a Roth conversion should work closely with the financial adviser and CPA to calculate the maximum IDCs they can use without hitting AMT levels. Not all is lost if you exceed your limit to deduct the IDCs. If you go over the amount which can be used in a particular year, the excess carries forward to the next year.

Donor Advised Funds (DAF)

If a client is charitably inclined and annually makes deductible gifts to charity, one potential solution is called a Donor Advised Fund (DAF) which can be used to accelerate his charitable deductions over several years to realize a present-year tax deduction.

A cash charitable deduction is able to reduce AGI by 50 percent, so if a client had $200,000 of income, the most they could place in a DAF in a given year would be $100,000, thus reducing their net income by that amount. They could place more, but the excess would have to carry forward to the next year’s tax return.

DAFs are very beneficial, if a client is charitably inclined, to reduce the conversion amount of Roth IRAs.

Renewable Energy Tax Credits

As a means for the government to incentivize private participation in the development of green technologies such as wind, solar, clean coal, and so forth, they issue the companies which are involved in these technologies federal tax credits under IRS Section 45.

These companies have the ability to sell these tax credits to private individuals or corporations at a discount.

For instance, you could invest $65,000 in a green technology company and they would sell you company stock with an associated $100,000 federal tax credit. Effectively you just paid 65 cents on the dollar for tax.

Once you make your investment, you should never expect to see that money again as the start-up costs for these companies usually eats it all up. That being said, if you were going to pay taxes of $100,000 on your income, paying $65,000 for the green credits to satisfy the $100,000 federal tax bill keeps the remaining $35,000 in your pocket.

As an aside, if you buy too many tax credits, they can be carried forward 20 years or can be carried back to the prior year’s tax return to reclaim taxes already paid.

Conservation Easements

In the early 1960s and 1970s, around large cities with tremendous development going on, a desire to preserve open space grew to the point where the government began incentivizing large land owners to not develop their land. The government would allow the land owner to give an appraisal of the developed land value after subtracting the value of the raw land to equal a charitable tax deduction.

For example, let’s say a parcel of land is worth $1M. If this parcel was fully developed it would appraise for $5M. If the farmer donates the developmental right to the land as a conservation easement, the farmer will be given a charitable tax deduction of the difference between the appraised value and the raw land’s value, in this case, $4M.

These tax deductions are only good for 12 years and many of these large land owners did not have enough income to make it worth their time, so they found a way to sell off their land-development rights to what are called Green Preservation Trusts. Treasury Regulation 1.170A-14 spells out how conversation easements can be used or sold.

In the previous example, an investor in a green preservation trust would receive $4 in charitable tax deductions for each $1 donated. Due to the charitable nature of this gift, it is limited to 30 percent of Adjusted Gross Income.

Back to Bob and His $280,000 Tax Bill

Let’s go back to our example of Bob with his now reduced tax bill of $280,000. Let’s say we combine two of the four additional means of reducing his out-of-pocket expense.

Using a conservation easement trust and noting a maximum of 30 percent AGI charitable reduction limit, Bob with $700,000 of income to report could use up to $210,000 of charitable deductions.

Conservation Easement Trust typically will provide a leverage ration of between 2 to 1 and 5 to 1. That means you invest $1 into one of these trusts and you will receive between $2 and $5 of charitable deductions. For our hypothetical example, let’s assume a 4 to 1 ratio, meaning he could place $52,500 into one of these trusts and realize the $210,000 charitable deduction, knocking down his reportable income from $700,000 down to $490,000.

Then, assuming he is in the top 35 percent federal tax bracket on this reportable income. His total tax bill would be $171,500.

Using a Renewable Energy Tax Credit, it would take only $111,475 to offset the $171,500 tax bill.

Summarizing Bob’s cost to eliminate his Roth IRA conversion tax bill:

Bob utilized several strategies for his Roth IRA conversion. The net cost out of Bob’s pocket was $173,975 or 17.4 percent of the value of his IRA.

$1,000,000 × 17.39 percent = $173,975

My final recommendation was for Bob to refinance his home which was paid off, and convert this tax bill into an amortizing payment over 30 years.

With interest rates at historic lows, a 4 percent 30-year fixed mortgage of $173,975 would carry an annual payment of $9,972.

Considering he just converted $1M of an IRA into a tax free Roth IRA, his new Roth would only have to earn one percent per year to equal the payment. How much will his Roth IRA grow above the one percent per year depends on the investments, but with a well-diversified Wealth Code portfolio, Bob’s future could be pretty bright.

Do the Math

Taxes are likely to be considerably higher in the future, which means that a Roth conversion today is more likely to be a good idea. But there’s no substitute for a careful evaluation of your situation and consultation with a professional to determine if it makes sense for you. The bottom line is clear—to make the right decision you have to do the math.

What to Invest Roth IRA Balances In?

This is the third and final question. Over the long run, this is more important—from a tax savings standpoint—than any of the other issues I have discussed up to this point. After all, the Roth IRA assets are now under the shelter of tax-free growth, and you sure do not want to leave the funds invested in a low yielding bank environment. In fact, the Roth IRA is where you may want to position your more aggressive investment positions, especially if you are not anticipating needing the money during your lifetime, and it is considered a legacy asset. If you take advantage of the discounted valuation strategy, utilizing market alternative investment strategies which have timeframes ranging from three to 10 years or more, then your course is already set for the next few years.

Beyond this, what to invest in is a question best left to discussions with your investment professional based upon your specific risk tolerances and financial objectives. Many Roth IRA owners will name grandchildren, rather than children, as beneficiaries of Roth IRAs, in order to preserve the tax free treatment of the Roth IRA over another 20 to 30 years of the third generation’s lifespan. This additional time frame may allow different types of investments to be considered, thus allowing time to be an ally in growing the legacy asset for future generations.