Financial Planning > Tax Planning

Year-End Tax Strategy: Pairing a Roth Conversion With a DAF

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This year is quickly coming to a close, and 2013 will be here before we know it. Let the confusion begin! With so much uncertainty still out there as we approach the New Year, many clients are looking for last-minute planning ideas that they can implement before year-end. 

There is a strong consensus with regard to the expected upward direction of tax rates for high-income earners in the near future. Not only do most expect to see an increase in their marginal income tax rates due to the expiration of the Bush-era tax cuts, but they will also be affected by the new 3.8% Medicare surtax applied to net investment income over certain modified adjusted gross income thresholds (specifically, $200,000 AGI for single taxpayers or heads of households and $250,000 for married taxpayers filing jointly). 

In light of impending income tax increases, clients are looking for ways to accelerate the realization of income into 2012, pay the tax liability at the current rates, and position themselves to minimize or avoid exposure to the anticipated higher marginal income tax rates, as well as the new surtax. One planning strategy that may go a long way in helping your clients achieve those goals is a Roth conversion.

Pros and Cons of Roth Conversions

If your clients hold assets in IRAs, they may want to consider a Roth conversion before the end of 2012. As the name suggests, a Roth conversion allows a client to convert existing IRA balances to Roth balances. Following changes to tax laws that took effect on January 1, 2010, there is no longer an adjusted gross income (AGI) limitation associated with the ability to convert, so this is a strategy available to earners at all levels of income. A conversion is relatively easy to complete, so you may still have time to do this by year-end. 

So why wouldn’t everyone convert an existing IRA balance to a Roth? The answer is simple: income taxes. When a client elects to convert an existing IRA to a Roth IRA, the amount converted is subject to ordinary income tax at the taxpayer’s marginal rate. Although the Roth conversion may be viewed as a great opportunity, it is often difficult to get a client to move forward with the conversion. Such reluctance is generally due to the immediate income tax liability associated with the conversion, even though most expect that those same IRA balances will be subject to higher income taxes in the future. Is there a way to help clients overcome their hesitation? For the right client situation, the answer is yes.

When tax liability presents itself as a hurdle to what may otherwise be a good planning opportunity, I always ask whether the client has any charitable intent or a consistent history of annual charitable giving. If the answer is in the affirmative, I know that there may be more flexible ways to approach any financial planning strategy by incorporating some aspect of charitable planning. 

Because, as noted above, the AGI limits that once denied higher-income earners from completing Roth conversions have been removed, I have been suggesting, where appropriate, pairing the establishment of a donor-advised fund (DAF) with a Roth conversion. 

Specifics on Donor Advised Funds

A DAF is an account administered by a public charity to accept donations from a donor (i.e., your client). It may be managed by the donor’s financial advisor (i.e., you) to distribute funds to other charities in the future. Donations to fund the DAF are generally tax deductible in the year in which they are made.  

Once your client contributes to a DAF, he or she becomes a grant advisor to the fund, meaning that your client can make recommendations to the DAF-sponsoring charity as to the timing, amount and recipients of future distributions from the fund. Although the grant advisor’s recommendations are nonbinding, as long as the recommended distribution is to a qualified charity the sponsoring charity will generally follow the donor’s suggestion.

How to Pair a Roth Conversion With a DAF, and for Whom

For clients with philanthropic goals, a Roth conversion paired with a DAF can be a very appealing strategy. The client can establish a DAF, which will provide an immediate income tax deduction that may reduce or eliminate the federal income taxes arising from the Roth conversion. Once completed, the client has successfully converted otherwise taxable IRA assets to a Roth, where those assets can grow and eventually be distributed tax-free. 

What type of client would benefit from such a pairing?

When reviewing your client base to determine who may most benefit from pairing a DAF with a Roth conversion, you should keep the following points in mind:

  • Is the client a high-income earner who can expect to see even higher income tax liability in the future? If so, note that the converted balance will not be subject to future income tax upon distribution.
  • Does the client regularly give to charity? If so, the DAF can be a way to front-load charitable giving funds to be dispersed to charities over time.
  • Does the client have assets outside of his or her IRA to contribute to the DAF? When determining how to fund the DAF, always look for capital assets that have a long-term capital gain. Upon contribution to the DAF, the client will receive an income tax deduction based upon the fair market value of the asset. The client will therefore avoid any capital gain associated with the contributed position.

Taking Action Now

Although certainly not for everyone, pairing a DAF with a Roth conversion can have a powerful impact upon the right client’s financial plan, but you should act now. There are operational aspects associated with establishing and funding the DAF, as well as executing the Roth conversion, which must be completed to ensure that the plan comes together properly. 

Because there are specific rules regarding the client’s AGI and deductibility to consider, be sure to work closely with the client’s tax professional in determining the amounts to convert and contribute. If all is aligned properly, your client can create a charitable legacy while securing a tax-free account from which to fund retirement and wealth transfer goals into the future. 

Commonwealth Financial Network® does not provide legal or tax advice.