Roth individual retirement accounts offer the enticing benefits of tax-free growth and the ability to make withdrawals during retirement when certain conditions are met.1 But prior to this year, there was an income restriction on who could convert a traditional IRA to a Roth IRA. Beginning this year, the eligibility requirements for conversion changed: Now, even taxpayers with modified adjusted gross incomes of more than $100,000 can shift assets held in traditional IRAs and other retirement vehicles to Roth IRAs. According to a 2010 Fidelity Investments study (the Fidelity Study),2 40 percent of clients working with tax advisors are now eligible to convert their qualified retirement savings plan to a Roth IRA, up from 13 percent in 2009, and 35 percent of these clients are expected to complete a conversion by year-end.

But making the decision whether to convert isn't an easy one. Taxpayers need to consider their time horizon, taxable income and perhaps most significantly, their ability to pay the income taxes incurred when converting. The income tax can be daunting and is essentially an out-of-pocket cost out of a client's taxable accounts. So your role, as an advisor, is to first look at whether it makes sense for your client to convert to a Roth IRA. If so, you should suggest strategies to reduce your client's income tax liability. And that's where tapping into your client's philanthropy comes in: A donor-advised fund (DAF) may be the optimal strategy to offset the tax cost of a Roth IRA conversion and support your client's charitable planning objectives now and in the future.

To Convert or Not to Convert?

Although public interest in Roth IRA conversions is high, tax advisors say their clients express reservations about converting to a Roth IRA, mainly because of the tax cost. Because the amounts converted from a traditional IRA to a Roth IRA is considered taxable income, this can translate into a significant tax bill in the year of the conversion.

Though individuals can choose to include the entire amount in income in 2010, there's a special provision that allows individuals to spread the taxable income from a 2010 Roth IRA conversion evenly over years 2011 and 2012.3 In the Fidelity Study, tax advisors responded that 54 percent of their clients would take advantage of this one-time opportunity.4 Nevertheless, you should caution clients to carefully consider this strategy, because the possibility of rising tax rates or increased income may result in a higher tax liability.

Whether they decide to spread the taxable income over the next two tax filing years, individuals still need to understand the up-front costs to a partial or full Roth IRA conversion. In essence, the benefit is that they're accelerating the payment of future taxes in return for tax-free income later.

There are also deadlines to consider. To take advantage of the two-year provision or to avoid a potential higher tax rate, individuals need to make the decision to convert by Dec. 31, 2010. Even then, they can change their minds; if so, they have until Oct. 15, 2011 to “recharacterize” their IRA or move the money back into a traditional IRA. This recharacterization essentially undoes the conversion without the need to pay taxes on it or incur any type of penalty.

The Charitable Offset

Individuals who are already charitably inclined and donate regularly and generously to non-profit organizations can offset some of the tax cost of a Roth IRA conversion through their charitable giving. In the same year the taxable income is realized, individuals can make one-time donations to the charities they support — but those contributions may need to be larger than those they usually make.

By accelerating future charitable contributions and donating them in the same year as the Roth IRA conversion, taxpayers can take a deduction for the charitable donations5 against the income tax liability resulting from the Roth IRA conversion.

The reason for the offset is simple: The tax deduction for a contribution to a public charity can be up to 50 percent of adjusted gross income for cash donations and up to 30 percent for donations of securities (generally deductible at fair market value when they're long-term appreciated securities). The larger the charitable donation, the more it can help reduce taxes and therefore the tax cost of a Roth IRA conversion.

In these situations, your client would not only need to have enough liquidity in a taxable account to pay the tax cost of the conversion, but also need available assets to make the charitable donation. Moreover, the strategy would certainly have to fit within his existing financial plan and long-term goals.

How it Works

Here's the charitable offset strategy6 in action. Let's assume John and Mary (a married couple), earn $145,000 before taxes, with annual itemized deductions of $34,000. They have $850,000 pre-tax in rollover IRAs and sufficient additional assets to pay the tax cost of a conversion to a Roth IRA. Importantly, they donate $10,000 to various public charities every year. If they were to convert the entire rollover IRA amount to a Roth IRA, the estimated actual tax cost of their conversion will be $286,545:

  • First, calculate taxable income with no conversion and no charitable contribution as $111,000 ($145,000 wages less itemized deductions of $34,000).
  • Second, calculate taxable income with a conversion and any applicable charitable donation (($145,000 wages + conversion amount) less itemized deductions ($34,000 + deductible charitable donation)).
  • Third, apply the 2010 federal ordinary income tax rates for a married couple, filing jointly, for each of the taxable income amounts determined in the prior two steps: 10 percent on the first $16,750 of taxable income; 15 percent on the next $51,249; 25 percent on the next $69,299; 28 percent on the next $71,949; 33 percent on the next $164,399; and then 35 percent on any remaining amount.

The difference between those two tax results is the estimated actual tax cost of the conversion. With no conversion and no charitable contribution, federal income taxes would have been $20,112. With a conversion and no charitable contribution, John and Mary's tax cost would be $286,545. But if they made a conversion and had sufficient additional assets to also make total qualified charitable donations of $211,000 that same year, the estimated reduced tax cost of conversion would be $212,695 — that's $73,850 less than it would have been without the offsetting charitable donations.7 (See “The Charitable Offset Strategy in Action,” this page.)

DAFs

What if such a large one-time donation directly to charities isn't part of John and Mary's overall giving strategy — for example, if they prefer to make annual donations to their favorite causes over many years? In that instance, John and Mary should consider making their donation to charity with a DAF. For example, John and Mary can put their $211,000 contribution in a DAF and recommend grants to charities over time, instead of making large, one-time donations to the ultimate grant recipients in that same tax year.

This longer-term giving strategy can also benefit certain smaller charities that prefer to spread large donations over time so the amounts don't artificially inflate their overall public support numbers, making fundraising more challenging.

Establishing a DAF can support both current and future giving strategies. Here's how it works:

  • An individual or couple makes an irrevocable donation to a public charity with a DAF program. Donations can be in the form of cash, publicly traded securities, certain private C corp. shares and S corp. shares and even certain limited liability company and limited partnership interests, depending on the specific charity.
  • The individual/couple become donor/advisors with respect to their contribution and are eligible to take an immediate tax deduction based on the amount and type of the contribution in the year it's made. The tax costs of the Roth IRA conversion are thereby offset by this charitable contribution.
  • The assets in the DAF are invested, and the donor/advisors can recommend how the assets are allocated among the charity's investment options.
  • The donor/advisors can recommend grants to eligible grant recipients as defined by the charity's guidelines (typically Internal Revenue Service-qualified public charities) now and over time, enabling the donor/advisors to continue their original charitable giving strategy of providing regular, periodic support for the causes they care about.

Donating Appreciated Securities

Contributing appreciated securities can provide even further tax savings. Your client can donate to public charities almost any appreciated securities — stocks, bonds and mutual funds — with long-term unrealized gains. (See “Donor-advised Fund or Private Foundation,” p. 62.) A taxpayer can take an itemized federal income tax deduction for the full fair market value of the securities — up to a limit of 30 percent of an individual taxpayer's adjusted gross annual income.8 Since the securities are donated rather than sold, the taxpayer avoids capital gains taxes that would have been triggered by the sale of the appreciated securities.

Nevertheless, donating securities with unrealized gains means choosing which charity to contribute to or how to allocate various amounts among several charities. Especially with large quantities or sums, charities that offer DAFs can help make this decision easier, as they can accept and liquidate the contribution more efficiently and without undue burden on the operations of individual charities.

DAFs often make the process easy and cost effective, whether the end recipient is one or multiple charities. Contributing assets directly requires working separately with each organization, which can take a substantial amount of time and effort for them and the donor. Many small charities also either don't accept appreciated securities at all or will only consider them for very large donations.

Charities that do accept appreciated securities often use full-service brokers and generally pay much higher commission costs than they would if they used DAFs like the Fidelity Charitable Gift Fund (the Gift Fund), which uses a discount broker. Thus, the net proceeds that a charity receives from the Gift Fund may be greater than the net proceeds the same charity would get from securities donated directly to it.

Leaving a Legacy

DAFs offer services that support immediate, future and legacy giving strategies. For example, at the Gift Fund, donor/advisors can transact online, on the phone or by paper forms. The Gift Fund has a program that enables donor/advisors to recommend grants to IRS-qualified public charities at virtually any time.

As they recommend grants to charities, donor/advisors can also recommend special purposes for how the grants should be used. Grant recommendations also can be set up as recurring or to be made on a specific date in the future. Donor/advisors can remain anonymous on the grants — a benefit that private foundations (PFs) can't provide, as all grants made from a PF will ultimately be reported on the PF's publicly available IRS Form 990-PF.

At a DAF like the Gift Fund, there's a variety of options for individuals and their families to perpetuate their charitable legacy while potentially maximizing income tax and estate tax advantages beyond their lifetimes. Donor/advisors can recommend other individuals as successors, to assume the privilege of recommending grants and investment allocations. Donor/advisors can also recommend one or more of their favorite qualified charities as successors where, upon the last donor/advisor's death, the recommended organizations may receive in a lump sum the balance of donor/advisor's DAF.

There are several other ways to leave a charitable legacy when a charity with a DAF program is a beneficiary of a donor's estate, or is a beneficiary of a qualified retirement plan, life insurance policy or trust (including a charitable remainder or charitable lead trust). In these cases, the documents should be written to name one or more individuals as the future donor/advisors when the DAF is set up.

Think Before You Act

The resultant tax from a Roth IRA conversion is a key consideration for individuals and their advisors. Qualified charitable donations can help offset the tax cost of the conversion, but this only makes sense if the taxpayer is already charitably inclined. If your client's plan is to continue giving to charities over the years instead of making one-time large donations in the year of a conversion, now's the time to consider a DAF to support current tax planning strategies and future support for charities.

Determining whether someone will benefit from a Roth IRA conversion requires careful analysis. There are many factors that come into play, including your client's age, time horizon, financial goals and more. Run the numbers, weigh the options and be sure to include future scenarios, like higher tax rates for different tax brackets and increasing amounts of projected income. Where tax costs are concerned, the bottom line is pay now or pay later. For charitable deductions, it's give now or give later.

Information provided is general and educational in nature. It is not intended to be, and should not be construed as, legal or tax advice. Rules and regulations regarding tax deductions for charitable giving vary at the state level, and laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of the information provided.

Endnotes

  1. A distribution from a Roth individual retirement account is tax-free and penalty-free provided that the “5-year aging requirement” has been satisfied and that at least one of the following conditions is met: the taxpayer reaches age 59 ½; the distribution is to the taxpayer's beneficiary after the taxpayer's death; or the distribution is used for a qualified first-time home purchase.

  2. Data for the Fidelity Investments Study (the Fidelity Study) was collected between Jan. 27, 2010 and Feb. 1, 2010 by Data Star, Inc., through its national online survey of 493 tax advisors.

  3. “Internal Revenue Code Section 408A(d)(3): Rollovers from an eligible retirement plan other than a Roth IRA.

    (A) In general. Notwithstanding sections 402(c), 403(b)(8), 408(d)(3), and 457(e)(16), in the case of any distribution to which this paragraph applies —

    1. there shall be included in gross income any amount which would be includible were it not part of a qualified rollover contribution,
    2. section 72(t) shall not apply, and
    3. unless the taxpayer elects not to have this clause apply, any amount required to be included in gross income for any taxable year beginning in 2010 by reason of this paragraph shall be so included ratably over the 2-taxable-year period beginning with the first taxable year beginning in 2011.

    Any election under clause (iii) for any distributions during a taxable year may not be changed after the due date for such taxable year.” (emphasis added)

  4. Fidelity Study, supra note 2.
  5. Assume a donation to IRC Section 501(c)(3) public charities with a 50 percent limit on cash contributions and a 30 percent limit on security contributions in aggregate as a percent of adjusted gross income. Gifts to charity are irrevocable and non-refundable.
  6. As with any tax planning strategy, there may be additional considerations that pertain to a taxpayer's unique situation. Other strategies may provide more flexibility and similar savings, including utilizing other deductions and/or converting an IRA over several years. Taxpayers should consult with their tax advisors for advice.
  7. Results assume no phase-out of itemized deductions, and state and local taxes aren't taken into account. This is a hypothetical example. Tax results will vary and depend on an individual's unique tax situation.
  8. The 30 percent limit doesn't apply to corporations; rather, a limit of 10 percent of taxable income is applicable to corporations contributing to charity.

Sarah C. Libbey is the president of the Fidelity Charitable Gift Fund and president of Fidelity Charitable Services in Boston

Donor-advised Fund or Private Foundation

To where should you donate your securities?

When contributing to a public charity — including one with a donor-advised fund (DAF) program — the deduction limitation for donating long-term appreciated securities is 30 percent of adjusted gross income (AGI), generally deductible at fair market value (FMV). Donating the same securities to a private foundation limits the deduction to 20 percent of AGI, also generally deductible at FMV.

In the case where the deduction for a donation to a private foundation exceeds the 20 percent AGI limit, the taxpayer may need to carry forward some of his deduction. Contributing to a DAF can help avoid the need to carry forward the deduction for an additional year — at least to the extent of the next 10 percent of AGI.
Sarah C. Libbey, Fidelity Charitable Gift Fund