As the end of each year approaches, our team of wealth strategists gives special emphasis to actions that can be taken before December 31st to minimize our clients’ tax burdens. Often, we coordinate this effort in conjunction with clients’ plans to contribute to causes they care about.
Generally, tax planning solutions revolve around either deferring income to future tax years, and/or accelerating deductions into the current tax year. Age, employment status and level of income are among the items that will determine the techniques that are available for income deferral.
On the other hand, there is usually more flexibility when it comes to managing deductions. A common deduction that many people take advantage of is the charitable deduction. For those who are charitably inclined, the current environment with relatively high levels of unrealized gains presents opportunities to meet your charitable goals while also improving the tax efficiency of your portfolio.
You may already be aware of a basic charitable gifting strategy that is used to improve tax efficiency: donating appreciated stock. By gifting stock rather than cash, you avoid realizing a taxable gain, and the charity can sell the stock with no tax consequences. The donor also receives a tax deduction for the full market value of the gift. We work with many of our taxable clients to simplify this process for them.
Explore the Benefits of Donor Advised Funds
You can further improve the tax efficiency of your charitable giving by establishing a “donor advised fund. A donor advised fund is a philanthropic account established at a public charity for the purpose of managing charitable donations for organizations and individuals. It allows the donor to make a charitable contribution, receive an immediate tax benefit, and then recommend grants to be disbursed to charities when you are ready.
You can think of a donor advised fund as a charitable savings account. The donor can make contributions to the fund as they would like and recommend grant disbursements as they see fit. Balances remaining inside the donor fund can be invested in a tax-free environment then disbursed to charities at a time of your choosing. Fortunately, the primary custodians that we work with all have charitable divisions or partners that sponsor donor advised funds.
The flexibility offered by a donor advised fund effectively separates the management and timing of taking charitable tax deductions from the actual disbursement of money to the charities. Since the taxable activity generated from your investment portfolio will vary from year to year, contributions to the donor advised fund can be altered or suspended depending on your tax situation. However, this does not affect your ability to continue sending grants from the donor fund to your supported charities each year. The timing of when and how much to take in charitable tax deductions can be better matched with your annual adjusted gross income.
Let’s Look at An Example
Suppose you routinely give a total of $5,000 each year to various charities, and there is a stock position in your portfolio that we have determined needs to be sold based on valuation. The stock has a market value of $30,000 and a cost basis of $10,000. If the position is sold, you would owe tax on the $20,000 gain.
An alternative strategy is to donate the stock position to the donor advised fund, which produces a charitable deduction of $30,000 for the year. Once transferred to the donor fund, the stock is sold with no tax consequence. You can then recommend grant disbursements that total $5,000 to the charities, and the remaining $25,000 balance in the donor fund can be reinvested.
You have in effect pre-funded five years’ worth of charitable contributions. If in the following year the stock market loses value and there is minimal taxable activity in the portfolio, you could find that you do not need to take charitable tax deductions to reduce your taxes. You can still recommend grant disbursements from the donor advised fund that total $5,000.
Although donor advised funds can provide taxpayers with additional flexibility in managing charitable tax deductions, they are not necessarily the best solution for everyone. In addition, the deductibility of charitable contributions is limited by the amount of adjusted gross income each year, so careful coordination with your CPA is needed to optimize the donor advised fund strategy.
Qualified Charitable Distributions
For retirees over the age of 70 ½, understanding Qualified Charitable Distributions (QCDs) and how they relate to Required Minimum Distributions (RMDs) can have a meaningful impact on your tax return, as well. A QCD is a cash gift from your IRA to a 501(c)(3) charity. Limited to $100,000 in value per year, making a QCD can count toward satisfying your RMD. (Note: QCDs cannot be sent to donor advised funds).
Reducing your income through a QCD may also reduce other incremental taxes and help avoid increases in Medicare premiums. With more taxpayers using the standard deduction and losing the tax advantages of traditional charitable contributions, QCD’s are an excellent way to reduce taxes through charitable giving.
If you do pursue a QCD, it’s critical to pay attention come tax time. When you receive your 1099-R form, the QCD will appear on the report as a normal distribution, making it taxable. You must tell your CPA / tax preparer about any charitable contributions you made with your RMD to reflect them accurately in your tax filing.
Whether you’re already taking advantage of these charitable contribution vehicles or would like to do so moving forward, talk to your CornerCap team as well as your CPA about the specifics of how these techniques apply to your situation.