Offsetting a Roth Conversion with a Charitable Donation

As explained in earlier articles, the traditional 401(k)/IRA (traditional account) can be considered a joint venture between the employee/retiree and the government. When the employee initially invests, the government also can be thought of as putting up money—the otherwise-owed income tax on the earned income. It is as if the government collects that tax and then invests it in the joint undertaking. The part of the venture the employee/retiree owns is exempt from all income and capital gains tax and is in effect a “Roth” within the traditional account. The income tax payment on conversion of a traditional account to a Roth account is in this view not really a tax but merely the fair price of buying the government’s ownership share at current market value. By paying this tax with outside money and increasing the employee/retiree’s ownership of the venture to 100%, the employee/retiree shifts dollars from a taxable vehicle to a tax-exempt one. In a flat-tax world, the conversion is costless and beneficial.

Despite these advantages, the traditional account is better than the stand-alone Roth account for bequests to charities (including a donor-advised fund). If an employee/retiree names a charity as the beneficiary of a traditional account, the donation at death is not only the employee/retiree’s share of the joint venture traditional account but also the government’s portion (generated through the government’s initial investment).

The Roth conversion is, however, worth considering for a traditional account for which the owner does not plan to name a charitable beneficiary.

With a progressive income tax, the government’s percentage ownership of the traditional 401(k)/IRA may differ at conversion and would-be distribution. One crude rule of thumb is that conversion is advantageous when the government’s percentage ownership (tax rate) at would-be withdrawal from the traditional account is the same or higher than at conversion. Thus, the conversion may be undesirable for an individual presently in an elevated tax bracket or if the conversion itself will move her into such a bracket.

Instead of paying the tax on a Roth conversion, suppose someone combines the conversion with either an equal qualified charitable distribution (QCD) that satisfies part of an annual required minimum distribution (RMD) or an equal deductible gift to charity. This piece explores the merits of these two strategies.

I. Use of a QCD

What is a QCD? If an employee/retiree meets the minimum age requirement of 70½, a QCD enables her to withdraw up to $105,000 per year from a traditional IRA (not a 401(k)) and direct that distribution to one or more qualified charities other than a donor-advised fund (DAF). That amount counts toward the annual RMD, if any. The QCD is not treated as an itemized charitable deduction and does not preclude the standard deduction.

A. Basic Example

Suppose a retiree is subject to an RMD from her traditional IRA of at least $100 and that she can satisfy $100 of this RMD with a $100 QCD, which she can pair with a $100 Roth conversion. For analytical purposes, one can view her $100 QCD as having two parts, a $100 taxable income withdrawal and a $100 taxable-income-reducing gift to charity. With or without the QCD/conversion combination, she adds $100 in taxable income.

• Without the QCD/conversion, she has $100 taxable income from the required RMD.
• With the QCD/conversion, she can be treated as having the $100 taxable income from the RMD but adding $100 conversion income and subtracting $100 from income because of the gift so that her taxable income is still just $100.

Assume further that the retiree is in a 50% tax bracket (for ease of analysis, with no progressive rates on different levels of income). With either the $100 RMD or $100 QCD/conversion (with the QCD treated as her RMD), she must pay $50 in income tax.

• With the QCD/conversion, she must use $50 of funds from outside the traditional account.
• With the RMD alone (no conversion), she can pay the $50 tax through withholding from the RMD and still receive $50 net.

To use the QCD/conversion offset, she must have adequate spare liquidity.

Assume in addition that she does have spare liquidity and that she would use $50 of outside money to pay the $50 tax on either the $100 RMD or the $100 QCD/conversion. Although the offset does not affect her $50 tax obligation, what does change?

After the QCD/conversion and offset, she has more of both of the following:

• $100 in charitable gift and
• $100 in a standalone Roth.

She also has less of both of the following:

• the $100 cash distribution (diverted to charity) and
• $100 in the traditional 401(k)/IRA (which she converted to standalone Roth).

B. Benefits and Burdens in the Basic Example

In the Basic Example, the employee/retiree must decide whether to simply take the RMD or to do a QCD/conversion. That requires both weighing the loss of $100 of traditional account against the gain of $100 (standalone) Roth and determining the value of making the charitable gift.

1. Weighing the loss of $100 traditional account against the gain of $100 standalone Roth account

Remember the initial premise that the traditional account can be considered a joint venture between her and the government: the part of the venture she owns is exempt from all income and capital gains tax and is in effect a “Roth” within the traditional account. The conversion moved money out of the traditional account. For $100 of traditional account, if she is in the 50% tax bracket, the government owned 50% ($50), and she owned the other 50% ($50). Her $50 was a “Roth” within. (To be precise, the government’s percentage ownership is based not on her current tax bracket but on the one at the time of withdrawal. For simplicity, this portion of the analysis assumes that the two are the same.)

As a result of the conversion, she lost that $50 “Roth” within the traditional account (and of course also lost the government-owned $50 of the traditional account); but she gained $100 in a Roth standalone account. So the net Roth gain from the QCD conversion (at the cost of diverting the $100 RMD cash to a donation) is:

• $50 in new Roth funds (i.e., the $100 new standalone Roth from conversion minus $50 pre-existing Roth within the traditional account).

The QCD/conversion has the additional gain of:

• $100 in charitable gift.

2. Considering the value of a donation

Change the Basic Example to Example 2, assuming instead that the employee/retiree received the required $100 cash RMD rather than directing it through a QCD to a charity and used that cash to pay the tax on a Roth conversion. Had she been in the 50% tax bracket (and the conversion did not increase her tax bracket), she could have converted $200 of traditional account to Roth, requiring a tax payment of $100 (made with the RMD). Fifty percent of the converted $200 traditional account, or $100, was a “Roth” within. So the net Roth gain from the conversion (at the cost of using the $100 RMD to pay the $100 tax on the $200 Roth conversion) is:

• $100 in new Roth funds (i.e., the $200 new standalone Roth from conversion minus $100 pre-existing Roth within the traditional account).

Disregarding the equal cost of the two examples (paid with outside funds), which of the above two alternatives is better—the Basic Example from subsection 1, resulting in the $100 in charitable gift and $50 in new Roth funds or Example 2 from subsection 2, resulting in the $100 in new Roth funds? The answer depends on how much the employee/retiree values the donation relative to the new Roth funds. So long as she values a $1 charitable gift more than fifty cents in new Roth funds, $100 to charity plus $50 in new Roth (with the QCD/conversion) is better than $100 in new Roth (with the RMD/conversion).

In any event, with the QCD/conversion offset, the charitable gift subtraction equals the conversion income addition. The two cancel regardless of tax bracket, even if elevated. Nevertheless, although the analysis assumed a high tax rate of 50%, the offset is beneficial only if she places a sufficiently large value on the gift to charity.

II. Use of a Deductible Gift to Charity Other than a QCD

The QCD has some drawbacks. An employee/retiree cannot contribute to a donor-advised fund (DAF), donate capital assets, or give more than $105,000 per year (indexed for inflation starting in 2024). To offset the cost of the Roth conversion, a possible alternative to the hypothetical $100 QCD in the Basic Example is a deductible $100 gift of either cash or appreciated capital assets to a qualified charity (including to a DAF), subject to the ceilings on deductibility that are generally set in terms of percentages of adjusted gross income.

To deduct a donation to a charity, a taxpayer must itemize. Continuing with the amounts in the Basic Example, if the employee/retiree’s standard deduction exceeds her other itemized deductions by $100 or more, the loss of that excess means that a $100 deductible charitable contribution will not offset the $100 income from a Roth conversion.

If the employee/retiree donates an appreciated capital asset, she would—subject to the limitations on the charitable deduction of such assets—escape capital gains on the appreciation. Especially with bigger gifts, the benefit of avoiding capital gains tax may exceed the downside of losing the standard deduction. (Congress has considered repealing the stepped-up basis at death, so this tax may become more difficult to avoid.)

To return to the $100 donation and gift, assume that the employee/retiree’s other itemized deductions exceed the standard deduction and therefore the $100 charitable deduction completely offsets the $100 conversion income. Even so, if donating an appreciated capital asset, she could convert substantially more by instead selling the capital asset, paying the capital gains tax, and using the net amount to finance the conversion.

Change the facts of Example 2 to a new Example 3. Assume that the employee/retiree has $100 in appreciated stock, with a basis of $50, and a capital gain of $50. Assume her capital gains tax rate is 30% and income tax rate is 50%. She can either sell the $100 of stock and use the after-tax proceeds to finance the tax on a conversion or donate the stock and use the charitable deduction to offset a $100 conversion.

With a sale of the $100 of stock, she would pay capital gains tax of 30% of $50, or $15. With the net after-tax amount of $85, she could pay the 50% income tax on a conversion of $170 from a traditional account. Of that $170 traditional account converted, 50%, or $85 was a Roth within, so the net Roth gain from the conversion is:

• $85 in new Roth funds (i.e., the new $170 standalone Roth minus the $85 pre-existing Roth within).

That net Roth gain is equivalent to the $85 income tax paid.

In contrast, had she donated the $100 appreciated stock to a charity and offset the charitable deduction against the income from a $100 conversion, she would pay no tax on the stock’s appreciation. On the $100 traditional account converted, 50% or $50 was a Roth within, so the net Roth gain from the conversion is:

• $50 in new Roth funds (i.e., the new $100 standalone Roth minus the $50 pre-existing Roth within the $100 traditional account).

In short, with the sale/conversion she gains $85 overall in new Roth funds; whereas with the donation/conversion, she gains $50 overall in new Roth funds and has a $100 contribution to charity (which could be a DAF). So long as she values a $1 gift more than 35 cents in additional Roth funding, the donation/conversion is better; but as before, if she does not sufficiently value the gift, the offset is not beneficial. That is true despite the example’s high tax bracket and advantages of a deductible gift’s complete offset of corresponding conversion income and avoidance of considerable capital gain on the sale of an appreciated asset.

In any event, the employee/retiree doing a conversion must have ready cash for the Roth conversion whether done alone or offset by a cash gift or QCD. If she does not have this liquidity but owns appreciated capital assets, she can instead donate some of them to counterbalance conversion income. (This piece will not address the merit of borrowing as a source of funds.)

III. Conclusion

Instead of paying the tax on a Roth conversion, an employee/retiree can completely offset a con-version with a QCD (if the QCD satisfies RMD) or fully or mostly offset a conversion using a deduct-ible charitable donation of cash or (better still) appreciated assets. Compared to paying the tax on the conversion, the result would be both substantially less total Roth funding (counting both standalone amounts and Roth amounts within a traditional account as explained here) and a significantly higher combined dollar amount of philanthropic gift plus increased Roth funding. The offset works—regardless of current tax bracket, even if elevated—but is beneficial if and only if the employee/retiree sufficiently values charitable gifts.