A Roth Conversion Using a Charitable Transfer

A Roth Conversion Using a Charitable Transfer

Article posted in Pooled Income Fund on 27 October 2016| 2 comments
audience: National Publication, William Walsh, CLU, CFP, ChFC, AEP | last updated: 27 October 2016


EzCharitable member, Bill Walsh, writes a compelling article about pairing a Roth IRA conversion with a new Pooled Income Fund.

By: William Walsh, CLU, CFP. ChFC, AEP

The Problem With IRAs

There may not be an asset class that presents a more intractable income and estate tax problem than retirement plans. IRAs, 401(k)s, pension and profit sharing plans, enable the successful business owner or professional to accumulate assets, tax deferred, for retirement, but create distribution and tax problems that may well exceed their  benefits.

In this discussion we will examine some (although not  all) of these tax problems and propose a solution using   a planned giving strategy that creates value not only for the retirement plan owners, but for their heirs and favorite charity as well.

Federal income tax rates are high and may be headed higher. Combined with state income taxes, a distribution from a retirement plan can be taxed at 50% or more. At death, retirement plan assets are taxed twice—once as income (IRD) and then again as part of the account owner's  estate.

There's more. Most retirement plans are invested. That is, the owner subjects his savings to the volatility of the investment markets in order to grow capital. Our tax system has traditionally rewarded this kind of risk- taking with a substantially lower capital gains tax rate. Yet in retirement plans, all gains, regardless of their source, are taxed as ordinary  income.

An Example Without Planning

Without Planning
• $6.4 million in RMD Income Taxes
• $3.7 million in IRD Taxes
• $14.1 million in Estate Taxes

$21.2 million for heirs

Let's look at an example. We will assume a husband and wife, ages 70 and 65, with a joint life expectancy of 21 years who are about to begin taking Required Minimum Distributions (RMDs) from their $5 million traditional IRA. They live in a state with a 5% income  tax and are therefore subject to a 45% marginal income tax rate. They have substantial other assets and will be subject  to  a 40% estate tax at the second death. In addition, they don't need the money. They have income adequate to meet their needs beyond the IRA. After taking the RMD each year, they plan to invest the after-tax proceeds. Finally, for the sake of this example, we will assume they have an after-tax fund (the side fund), also not needed to maintain their lifestyle, with a current balance of $6 million, [I suspect the side fund needs to be bigger to shelter the $5 million IRA conversion] into which they will deposit the after tax RMDs. We will assume a long term rate of return (ROR) on IRA assets of 9.9% and   will account for income taxes on the growth of the side fund by assuming a long term ROR of 7.2%.


  • Husband and Wife ages 70 and 65
  • 9.9% Rate of Return on IRA assets
  • 7.2% Rate of Return on non-IRA assets
  • 45% Marginal Income Tax Rate
  • 40% Estate Tax Rate

At their life expectancy, our couple will have taken RMDs totaling $14.1 million. They will have paid $6.4 million in income taxes on those distributions and the IRA will have a balance of $8.2 million. The side fund, into which the after-tax RMDs have been contributed, will have grown to over $30.8 million.

At the second death, the IRA will be subject to income taxes (IRD) of $3.7 million and the remaining balance of $4.5 million, along with the balance in the side fund will be subject to an estate tax of $14.1 million. This will leave the heirs a balance of $21.2 million. Total taxes on the two accounts, which began in our example with a combined balance of $11 million, exceed $24 million. Every penny was taxed at least twice. Such is the price of thrift.

A Roth Conversion

A Roth IRA, by contrast, has no distribution requirement and whatever lifetime distributions are made are not subject to tax of any kind, which brings us to the topic of this discussion. There is a technique that combines the conversion of an IRA into a Roth IRA in conjunction with a transfer to a charitable entity. We  will analyze a transfer into a newly formed Pooled Income Fund (PIF). A PIF is a split interest trust. That is, there   are two classes of beneficiaries, one is a public charity and the other is the donor, the couple in our example,  or their heirs. The donor or his designee is the income beneficiary and the charity is the remainder beneficiary.

What is a Pooled Income Fund?

A PIF, defined at IRC 642(C)(5), is a trust maintained by a public charity that accepts contributions from donors and commingles them with the contributions of other donors for investment purposes. Each year, all of the fund's income is distributed to the donors or their designated beneficiaries on a pro-rata basis.

As is the case with other charitable transfers, the donor will receive a charitable income tax deduction in the amount of the net present value (NPV) of the gift. While a Charitable Remainder Trust (CRT) or a Charitable Gift Annuity (CGA) could be used in place of  a PIF, in this Roth conversion technique, we are illustrating the use of a newly formed PIF. The rules governing the calculation of the charitable tax deduction for transfers into newly formed PIFs are advantageous as there is a substantial interest rate arbitrage.

Finally, a PIF can, with a few restrictions, accept all types of assets and hold them until they are sold. Transactions inside the PIF are not subject to taxation so a PIF is an excellent vehicle for disposing of low basis assets subject to capital gains  taxes. Returning to our example, we will assume the entire $6 million side fund is transferred to a newly formed PIF. The resultant charitable tax deduction will partially shelter the conversion of the $5 million IRA into a Roth IRA. We will also assume the PIF will return to the donor an income stream of 6% per year or $360,000.

Using a PIF
• No Income Taxes on the IRA at any time
• $3.5 million total tax reduction

$37.4 million for heirs
$6 million for charity

The PIF income payment is not fixed, as in an annuity. Instead it is the donor's share of the PIF's earnings, whatever those earnings happen to be. The 6% figure, while not guaranteed, is not unreasonable given the definition of PIF income and is taken from an actual example. PIF income is taxable to the recipient. Unlike an IRA, however, the earnings inside a PIF retain their character as they are paid out. That is, capital gains are paid as capital gains, royalties are paid as royalties, passive income as passive income and so forth. We will assume for the balance of this example that the PIF income is entirely ordinary and subject to the same 45% income tax rate. Income taxes will reduce the PIF income by $162,000 for a net of $198,000 to the  couple in our example.

At the second death the PIF corpus will revert to the charity. It will not be subject to estate taxes but will, of course, not be paid to the heirs. We will, therefore, assume that $65,000 [The life insurance premium may need to increase if the size of the side fund is increased but can be proportional] of the PIF's after tax income  will be transferred to an irrevocable life insurance trust (ILIT) for the heirs, where it will pay the premiums on a $6 million survivorship life insurance policy on the couple. The life insurance will replace the wealth transferred into the PIF. We will assume in this example that the couple has annual gift exclusions adequate to shelter the $65,000 and we will not otherwise account for gift taxes. The remaining $133,000 of PIF income will be invested into the side fund.

Is 6% Possible?

A PIF is a trust and the trustee must manage the assets for the benefit of all beneficiaries, in this case, the couple in our example and the charity. Managing for Income and Preservation of Capital is a reasonable investment objective. In addition, the trust can be written to define some portion of capital gains as  income.

A brief, non-exhaustive search for closed end funds at the Closed End Fund Connect web site returned 339 funds, out of 551 in its data base with this investment objective and with yields above 6% on average, over the last three years -- even in this low rate environment. Included were a diverse group of well known and respected managers and a range of investment classes.

  Investment returns are not guaranteed, of course, but a 6% income  objective is achievable.

In this example, at the second death, the Roth IRA and the side fund will have grown to $43.8 million and $8.5 million respectively. Estate taxes of $20.9 million will be due on these balances, but the proceeds of the $6 million in life insurance will be paid to the heirs free of estate and income taxes. The total $37.4 million, to the heirs, is $16.2 million more, an increase of 76% over the unplanned scenario.

Perhaps just as important and in addition, $6 million  will have been paid to our couple's favorite charity, a substantial gift, made during their lifetimes, where they can see, and perhaps help direct, how it is used in bringing their values into reality.

The ages of the donors and fund balances used in our example here are arbitrary. Smaller or much larger transfers work well as do younger or older ages. A donor can make transfers into several PIFs or multiple transfers into the same PIF. Its use is largely unaffected by other charitable strategies a donor may have used or may be using. This strategy does not require extraordinary legal or tax work. A trust agreement and other documents must be drafted, but they are conventional and do not require IRS approval or registration. This technique is not patented.

PIF Flexibility

A PIF is flexible. For instance, the wealth replacement life insurance is not required and lifetime benefits would increase for the donors if it were not used. Conversely, the entire PIF income could be transferred to the heirs' trust, tripling the amount of life insurance and substantially improving the outcome for the heirs. While some have strict gift acceptance rules that must be considered, any public charity can establish and benefit from a PIF. A donor can transfer cash or other types of assets, or both. Smaller charities typically use third party administrators of which there are several. The donor may include restrictions on how the charity may use the gift. If the gift is made to a university, for example, it could be directed towards scholarships, even limited to a particular field of study.

Without any planning, the couple in this example, with  a $5 million IRA and with $6 million in a side fund will pay, over their lifetimes, $24.1 million in taxes. By using  a PIF they will enjoy the financial and spiritual benefits  of making a substantial lifetime gift to charity while dramatically reducing taxes and creating value for themselves and their heirs.

PIF Arbitrage

A PIF is a Split Interest trust. That is, there are two classes of beneficiaries. In this case, the income beneficiary, the couple in our example, and the charity, who will receive the amount transferred at the second death.

The charitable income tax deduction is not the amount transferred, but the amount transferred reduced by the value of the income retained by our couple. The PIF rules specify that the value of the retained interest be calculated using the highest interest rate earned by the PIF over the last three   years.

So if the highest rate the PIF has earned over the last three years is 6%, the amount we expect to earn in our example, the tax deduction will be the amount transferred, $6 million in our example, minus the present value of the income, about $4.4 million. The charitable tax deduction in this case would be about $1.6 million. If the PIF averaged 6%, this would be completely fair.

But if the PIF doesn't have three years of history, the rules work very much in favor of the taxpayer. The calculation of the tax deduction for a transfer into a newly formed PIF uses the average of the past three years Applicable Federal Midterm Rate, minus one percent. As of October of 2015, the applicable rate is 1.2%.

That means that the same $6 million transfer would generate a charitable tax deduction of almost $5 million dollars. Since it is unlikely the fund would earn a return as low as 1.2%, indeed we expect it to earn 6%, the tax deduction amounts to an arbitrage in favor of the donor.


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Re: A Roth Conversion Using a Charitable Transfer

If you are going to convert to a Roth over multiple years because of the 50% contribution limit, I assume you will need to contribute to a different PIF after 3 years because it will no longer be considered "new", assuming you convert/contribute for 5 years.

Re: A Roth Conversion Using a Charitable Transfer

I think, you're asking more than one question. first, if you're doing a Roth conversion, you can do it all in one year since there is no limit on how much you can convert. Your charitable income tax deduction will always be limited to 50% of AGI so there is no reason not to utilize the ability to carry forward the excess deduction for prior years. as to having to use a different PIF, it depends. It's always important to do the analysis on a year by year basis

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