I have some bad news for you. If you own a qualified plan (IRA or 401(k)) then you may be in a possession of a bomb—a tax bomb to be more exact. For years the “High Priests of Finance” have been telling people to defer a portion of their income into these types of plans. Nearly EVERY Financial Blog and “Financial Expert” espouses the virtues of automatic savings, tax deferred growth, company matches, and high stock market returns. With over 6 Trillion in IRA assets, there is a 1.5 Trillion vig that the government will reclaim over the 20 years as the baby boomers age to 70½.
There are 2 “outs” for minimizing this ticking tax bomb:
- Make Charitable contributions from the distributions you take from your IRA. The IRS allows you to take up to $100,000 of your distributions every year and give that money to a qualified charity. They will not require you to pay any tax on the money you donated. This is only a workable strategy if you have other income streams to live on during retirement.
- Convert your traditional IRA to a ROTH IRA. This is a strategy which has been around for a while now. The thought process being, if I pay all the tax today (at today’s rates) then the growth on the money and the tax-free distributions should outweigh paying the tax now. The younger you are, the more this strategy makes sense. Of course, the younger you are, the likelihood that you will have enough cash around to pay the tax now is not very high.
So here is the dilemma. Do I convert my IRA to a ROTH IRA now and take all my available cash to pay the tax owed today, or do I plan on having other income streams so I can just donate my IRA away to avoid paying tax, or do I just do nothing and bite the bullet and pay the taxes in retirement on the income?
OR is there another strategy? HMMM. Why yes there is! You see the tax code is over 4 million words. To give you perspective, that is 4 times the size of all the Harry Potter books put together. Interestingly though, if you just take a look, you can find where clever law-abiding citizens can utilize the tax code to minimize their tax liability in numerous ways.
Allow me to explain an advanced strategy…
Enter: The Conservation Easement. A conservation easement is a voluntary and legally-binding agreement between a landowner and a land trustor government agency. When a landowner donates an easement to a land trust or public agency, she or he is giving away some of the rights associated with the land. The easement permanently limits uses of the donated parcel in order to protect its conservation values, as specified in the Internal Revenue Code (IRC) 170(h). Congress thought it was important to preserve land of historic or ecological importance, so they created tax incentives for those who voluntarily restrict their property in a manner that preserves these conservation values on their property in perpetuity.
A landowner who donates a “qualified” conservation easement to a qualified governmental entity or land trust, and who satisfies the technical requirements of the regulations issued under section 170, is eligible for a federal income tax deduction equal to the value of the donated easement. However, the value of restrictions placed on real property is a difficult question. In practice, the value of a conservation easement donation generally is measured by the difference between the fair market value of the property before the easement takes effect and the fair market value after the easement takes effect.
In other words, you would get a tax deduction for the value of the land at the appraised value of what its best use would be.
Now most of you are thinking, well I don’t own any land so how could I take advantage of this? Enter: The Syndicated Conservation Easement. This opportunity allows investors to partake in partnership where land is acquired and then voted on whether or not to put on an easement. Pretty cool.
So let’s circle back to what this has to do with converting your traditional IRA to a Roth IRA and not obliterate all your reserves to pay the taxes owed this year. Shall we?
So here is the strategy…
Once you convert your Traditional IRA to a Roth IRA, ALL of the money in the IRA is now considered taxable income to you. So, if you are a business owner who makes $250,000 in income and you convert your $300,000 IRA to a Roth IRA, your taxable income become $550,000. Yikes!! Assuming you paid your taxes on the $250,000 you are still going to owe probably 35% on the $300,000 you converted to a Roth IRA. That could mean another $105,000 in taxes you need to come up with!
Here’s where the advanced part of the strategy comes into play…
Let’s say you took $40,000 and invested in a conservation easement which provided you a tax deduction of $180,000. Now you would only owe 30% on $120,000 (300,000-180,000) which would be $36,000. Note: You would have to add in the $40,000 investment into the easement in addition to the $36,000 in taxes you owe which is $76,000. Now, here’s the tough question: Would you rather pay $105,000 in taxes or $76,000 in taxes? This strategy would allow you to convert your IRA at a potentially lower and predictable tax rate today, rather than hoping the 21 Trillion of debt doesn’t trigger tax rates going to 40-50% on producers in the coming years.
Is it perfect? NO, but it is an alternative to saving taxes. You would want to work with a licensed financial advisor to help you work out the numbers and talk to your accountant. I suggest you choose a reputable company to get the Conservation Easement through and document and disclose everything as the IRS requires, of course. You will most likely get push-back from an accountant who doesn’t fully understand Conservation Easements and they may be concerned about it being “listed Transactions.” It is considered a risky strategy, but it is legal and has been around for years.
Converting a boatload of IRA money to a potential tax-free income stream at a lower tax rate than what you would normally pay takes some courage and creativity, but so does owning and running a business. Combining a conversion of your Traditional IRA to a Roth IRA in conjunction with utilizing a Conversation Easement strategy is a powerful financial tool you can use if you qualify. Let us know if you want some help.
Do well, my friends!