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Can Charitable Donations Help Reduce the Tax Cost of a Roth IRA Conversion?

According to a recent Fidelity Investments® study, 40 percent of investors working with tax advisors are now eligible to take advantage of the recent removal of income limits for Roth IRA conversions, up from just 13 percent last year.1

A Roth IRA conversion may make sense for an individual who expects higher taxes in the future, has a long investment timeframe (more than 5 years), and can pay the tax cost of the conversion with non-retirement dollars.

With all the factors to weigh, often times, the very first question asked by an individual considering a conversion is, "What is this going to cost me?" The resulting tax cost of a Roth IRA conversion can be overwhelming — and people want to know what actions they can take to reduce it.

One possible strategy to reducing the tax cost of a Roth IRA conversion is to make an offsetting charitable donation. This strategy may be most appropriate for someone who already donates regularly to charity and has sufficient non-retirement assets to both: pay the cost of the conversion and make a (likely) larger-than-usual charitable donation in the year of the conversion.

By accelerating future planned charitable contributions and donating them in the same year as the Roth IRA conversion, an individual can apply the deduction from the charitable donations against the increase in taxable income resulting from the Roth IRA conversion.

The Charitable Offset Strategy2

Making a qualified charitable contribution may reduce the tax cost of this Roth IRA conversion by $39,200.3

Charitable Offset Strategy Graph

2 As with any tax planning strategy, there may be additional considerations that pertain to your personal situation. Other strategies may provide more flexibility and similar savings, including utilizing other deductions and/or converting your IRA over several years. Please consult with your tax advisor.

3 Estimated Actual Tax Cost of Conversion was estimated as follows: First, taxable income with no conversion and no charitable contribution was calculated ($145,000 wages less itemized deductions of $34,000 = $111,000). Second, taxable income with a conversion and any applicable charitable donation was calculated (($145,000 wages + Conversion Amount) less itemized deductions of ($34,000 + Deductible Charitable Donation)). Third, taxes were calculated by applying 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% on first $16,750 of taxable income; 15% on next $51,250; 25% on next $69,300; 28% on the next $71,950; 33% on the next $164,400, and then 35% 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, taxes would have been $20,112. Results assume no phase-out of itemized deductions, and state and local taxes are not taken into account. This is a hypothetical example. Tax results will vary and depend on an individual's unique tax situation.

4 Assume donation to 501(c)(3) public charities with 50% limit on cash contributions and a 30% limit on security contributions in aggregate as a percent of adjusted gross income (AGI). Gifts to charity are irrevocable and non-refundable.

While an offsetting charitable donation can be made to any charity, it may be most effective to make the donation to a public charity that offers a donor-advised fund program. With a donor-advised fund, you make a charitable contribution, become eligible to take an immediate tax deduction for the amount contributed, and can begin supporting charitable causes.

When you make an "offsetting" charitable donation to a public charity with a donor-advised fund program, you effectively frontload a "ready reserve” of charitable dollars, which can be invested for potential future growth. That "ready reserve" can be used over time to support many charitable causes.

The benefits of incorporating charitable giving into the Roth IRA conversion strategy:

  • Convert a larger percentage of eligible retirement assets to a Roth IRA in 2010 while reducing the tax cost of the conversion
  • Take advantage of the potential future tax-free growth of a Roth IRA
  • Effectively support charitable causes — and even "front load" future giving if the charitable donation is made to a public charity with a donor-advised fund program.

Ted and Angela

  • Living in Florida; Both in good health; Ages 57 (Ted) and 58 (Angela)
  • Earn $145,000 annually before taxes (Expect annual itemized deductions of about $34,000)
  • Have two college-aged children
  • Plan to retire when Ted is 67 and expect to begin taking withdrawals from the Roth IRA that same year
  • $500,000 pre-tax in Rollover IRAs
  • $400,000 in a taxable brokerage account
  • Donate a total of $10,000 annually to 3-5 charitable organizations

Roth IRA Conversion Goals

  1. Convert as much of their Rollover IRA to a Roth IRA as quickly as possible in order to avoid possible upcoming tax rate increases and take advantage of potential future tax-free growth with a Roth IRA.
  2. Ensure they have sufficient assets to cover the tax cost of converting, while continuing to support charities.

1 Data was collected between 01/27/10 and 02/01/10, by Data Star, Inc., through a national online survey of 493 tax advisors.

Information provided is general and educational in nature. It is not intended to be, and should not be construed as, legal or tax advice. Fidelity Charitable does not provide legal or tax advice. Content provided meant to illustrate taxation at the federal level only. 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. Charitable contributions are irrevocable and non-refundable. Availability of certain federal income tax deductions may depend on whether you itemize deductions. Charitable contributions of capital gain property held for more than one year are usually deductible at fair market value. Deductions for capital gain property held for one year or less are usually limited to cost basis. Consult an attorney or tax advisor regarding your specific legal or tax situation.

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The views and opinions of third-party content providers are solely those of the author and not Fidelity Charitable. Fidelity Charitable does not guarantee the accuracy of the information provided by such third parties. Information provided is general and educational in nature. It is not intended to be, and should not be construed as, legal or tax advice. Fidelity Charitable does not provide legal or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. Fidelity Charitable makes no warranties with regard to the information or results obtained by its use. Fidelity Charitable disclaims any liability arising out of your use of, or reliance on, the information. Consult an attorney or tax advisor regarding your specific legal or tax situation.