A Roth IRA conversion can be a savvy financial move, offering the promise of tax-free growth and withdrawals in retirement. However, the immediate tax implications of converting traditional IRA funds to a Roth IRA can be significant. One strategy to offset these tax consequences involves using a Donor-Advised Fund (DAF). This blog will explain  how combining charitable giving with retirement planning can be a win-win for a client’s finances and their favorite causes.

What is the Difference Between a Roth IRA and a Traditional IRA?

A Roth IRA is a type of tax-advantaged individual retirement account to which a person can contribute after-tax dollars toward retirement. Known as an individual retirement arrangement by the IRS, the primary benefit of a Roth IRA is that your contributions and the earnings on those contributions can grow tax-free and be withdrawn tax-free after age 59½, assuming the account has been open for at least five years. In short, the individual pays taxes on money going into the Roth IRA, and all future withdrawals are tax-free.

Roth IRAs are similar to traditional IRAs, with the biggest distinction being how they are taxed. Roth IRAs are funded with after-tax dollars. Unlike a traditional IRA, the contributions are not tax-deductible, but once a person starts withdrawing funds, the money distributed is tax-free.

So What Is a Roth IRA Conversion?

A Roth IRA conversion involves moving funds from a traditional IRA into a Roth IRA. While Roth IRAs offer long-term tax advantages, the conversion itself triggers a taxable event: the amount converted is treated as ordinary income for the year. Depending on the size of the conversion and the individuals’s tax bracket, this can result in a large tax liability.

What Is a Donor-Advised Fund?

A Donor-Advised Fund is a charitable giving vehicle that allows an individual to contribute assets (e.g., cash, stocks, or mutual funds) to an account dedicated to supporting charities. That person receives an immediate tax deduction for the amount contributed, and they can recommend grants to their favorite nonprofits over time.

How a Donor-Advised Fund Offsets Roth Conversion Taxes

1. Timing Contributions for Maximum Impact

If a client is planning a Roth IRA conversion, it is an ideal time to contribute to a DAF at the same time. The tax deduction from the DAF contribution can help offset the taxable income generated by the conversion.

Example:
Suppose a client converts $100,000 from a traditional IRA to a Roth IRA, increasing their taxable income by that amount. If they contribute $50,000 to a DAF in the same year, the tax deduction can significantly reduce their adjusted gross income, lowering the overall tax liability.

2. Leverage Appreciated Assets

Donating appreciated assets, like stocks or mutual funds, to a DAF offers additional tax benefits. The client avoids capital gains taxes on the appreciation while still receiving a deduction for the full market value of the donation.

Example:
Imagine your client owns stock worth $50,000 that they bought for $20,000. Donating the stock to a DAF avoids the capital gains tax on the $30,000 of appreciation and still allows them to deduct the full $50,000.

3. Bunching Contributions to Maximize Deductions

The standard deduction has increased in recent years, making it harder for some taxpayers to itemize deductions. By "bunching" multiple years' worth of charitable contributions into a single year through a DAF, your client can exceed the standard deduction and benefit from itemizing.

This approach pairs well with a Roth conversion, where the higher taxable income makes it more likely that the client will benefit from a larger deduction in the conversion year.

4. Reduce Future Required Minimum Distributions (RMDs)

Roth IRA conversions help reduce the size of your traditional IRA, thereby lowering your client’s future RMDs and their associated tax burden. A DAF contribution further decreases taxable income in the conversion year, creating a double benefit for retirees looking to optimize their tax strategy.

Key Considerations

• Contribution Limits:
  DAF contributions are subject to IRS limits on charitable deductions, typically 60% of adjusted gross income (AGI) for cash contributions and 30% for appreciated assets.

• Long-Term Planning:
  Ensure your Roth conversion and DAF contributions align with your client’s long-term financial goals. 

• Philanthropic Intent:
  While the tax benefits are compelling, remember that a DAF is a charitable giving tool. Only consider this strategy if your client is interested in supporting nonprofit organizations.

The Dual Benefit of Roth Conversions and DAFs

By pairing a Roth IRA conversion with a DAF contribution, a person can reduce their tax liability while supporting meaningful causes. It is a strategy that not only benefits their financial future, but also creates a lasting legacy of generosity.

Questions? Comments? Let us know here!