With the tax deadline fast approaching, wealth management clients are deciding whether they are going to convert from a traditional IRA to a Roth IRA.
But before they do, advisers have one more conversion strategy to offer their clients, according to Fidelity Investments: the "charitable offset" strategy.
Fidelity suggests that clients donate to a charity with a donor-advised fund program, such as Fidelity's Charitable Gift Fund, as an "offset" to help reduce the potential tax implications of a Roth IRA conversion in the conversion year.
Donors can give to any nonprofit to help offset taxable income, but some may not want to make a large one-time donation to a charity. With a donor-advised fund program, individuals can recommend several nonprofit organizations and can donate over a period of time.
According to a recent Fidelity survey of almost 500 tax advisers, 40% of investors working with tax advisers are eligible for a Roth IRA conversion now that income limits have been removed, and 35% are expected to complete a conversion by the end of this year.
Prior to Jan. 1, 2010, only individuals with modified adjusted-gross incomes of $100,000 or less were eligible to convert assets from a traditional IRA or a 401(k) with a previous employer to a Roth IRA. Clients who want to convert funds from a traditional IRA to a Roth IRA have to pay taxes on the amount to be converted, but there is also a one-time provision in 2010 that allows clients to spread their tax income from the conversion equally over the next two years, 2011 and 2012.
That's where the charitable donation comes in.
"Making a charitable contribution to a donor-advised fund is a strategy that advisers can use to help their clients offset the taxable income of a Roth IRA conversion, while at the same time establishing a 'ready reserve' of charitable dollars that can be used to recommend grants on their own timetable," said Sarah Libbey, president of Fidelity Charitable Gift Fund.
Charitable contribution offsets may provide the added benefit of allowing clients to convert a larger percentage of the IRA balance without being bumped into a higher tax bracket.
Charitable donations can be in cash, publicly traded securities, C-corp shares and S-corp shares, depending on the donor-advised fund program, according to Fidelity. Donors may be eligible for an immediate tax deduction of up to 50% of adjusted gross income (AGI) for cash contributions, or a deduction of up to 30% of AGI for contributions of securities. With long-term appreciated securities, the capital gains tax can be avoided.
David A. Handler, an estate attorney and partner at Kirkland & Ellis, cautions that in using the offset, "you're not actually coming out ahead; you're just reducing your income tax."
Handler says a charitable offset strategy makes sense for those clients who were planning on giving money away to charity in the next few years anyway. "But if you have no intention to give to charity don't try to give away $1 to save 40 cents. It won't ever add up. You're not ahead, but you didn't give any to taxes."