Journal of Financial Planning: October 2021
Philip Herzberg, CFP®, CTFA, AEP, is a lead financial adviser for Team Hewins, LLC, a fee-only financial planning and investment management firm in Miami and Boca Raton, Florida, and California. He utilizes his expertise to help clients implement tax-efficient investment, retirement, and estate planning strategies. He is past president of FPA of Florida, past president of FPA of Miami, and past president of the Estate Planning Council of Greater Miami.
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Charitable giving is a prudent and well-established strategy in year-end financial planning. Despite the ongoing coronavirus pandemic (COVID-19) uncertainty and challenges that have carried over from 2020 to 2021, the environment remains favorable for high-impact, tax-smart philanthropy during the upcoming holiday season.
What timely techniques can you employ, as a planner, to guide your clients in combining their desire to support the causes they are passionate about with their goal to save money on taxes? Assess the following viable income tax considerations in tandem with your clients’ charitable intentions.
Gifting Appreciated Non-Cash Assets
If your clients expect to itemize deductions, you should suggest they take advantage of the charitable deduction by making donations to lower their tax bills. High-income earners may enjoy a particularly sizable tax benefit from charitable contributions since they typically pay tax at higher rates.
Contributing highly appreciated, publicly traded securities has become a beneficial way for clients to minimize their taxes and maximize their philanthropic impact. When the donation of appreciated assets to a public charity is made, your clients can claim the fair market value as an itemized deduction of up to 30 percent of their current year adjusted gross income (AGI). Donation amounts in excess of this deduction limit may be carried over for up to five tax years.
Another incentive for giving long-term appreciated securities is that your clients generally do not pay capital gains taxes on the sale of donated assets that have been held for more than one year. This strategy can offset capital gains taxes that would be generated by portfolio rebalancing or selling the low basis assets and donating the proceeds. The upshot is that your clients may increase the value of their gifts to charities.
It is important to know that workers who receive bonuses in the form of stock from their employers can carry significant exposure to that company in their overall assets. Gifting shares of appreciated company stock may help your clients fulfill their philanthropic goals and diversify their investment portfolio’s risk to company stock, all while managing the impact on their capital gains taxes.
Setting Up a Donor Advised Fund
The Tax Cuts and Jobs Act (TCJA) of 2017 created a new challenge for many donors who had historically itemized deductions by raising the 2018 tax year standard deduction to $12,000 for single filers and $24,000 for married couples filing jointly. Suggest to clients who itemize deductions that they consider concentrating, or “bunching,” charitable contributions in a single year, then skip one or two years. The larger standard deduction can subsequently be taken in the alternating years.
This front-loading of charitable gifts enables your clients to maximize their deductions and could generate higher tax savings than spreading out charitable gifts over two or more different tax years. Your clients will benefit when they have the financial capacity to pack all of their deductions, beyond the standard deduction threshold, into a single year.
A donor advised fund (DAF) facilitates funding more than one year of giving in advance and provides continuous support to charities over time. Establishing a DAF enables your clients to make gifts, immediately qualify for a charitable tax deduction, and then give grants to IRS-qualified 501(c)(3) public charities over time. Until they are ready, donors do not need to decide on the charities to support with grant recommendations. Further, the assets in the DAF can be invested, so there continues to be an opportunity for growth over time.
Educate your charitably inclined clients about leveraging a DAF to offset a year with unexpectedly high earnings or to address the tax ramifications of year-end bonuses or stock option exercises. Be sure to evaluate whether a DAF is a suitable vehicle for your clients, as there are investment minimums and fees.
Donating Complex Assets
Philanthropists may also contribute complex and illiquid assets, including appreciated restricted stock, private company securities, limited partnership interests, real estate, bitcoin, and alternative investments, directly to charity. Even though donating these assets requires more time and effort than donating publicly traded securities, this process has unique advantages. Understand that these types of assets frequently possess a relatively low cost basis. Indeed, for some entrepreneurs who have founded their own companies, the cost basis of their private C-corporation and S-corporation stock may effectively be zero.
The caveat is that donating non-publicly traded assets to charity entails additional laws and regulations. Enlist the guidance of a qualified tax adviser and estate planning attorney to coordinate this charitable planning process. Be mindful that not all charities have the administrative resources to accept and liquidate complex assets.
Deducting Charitable Cash Gifts
Are your clients itemizing cash donations to public charities? There are meaningful tax incentives for charitable giving through provisions in the 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act that have been extended through 2021.
Individual donors who itemize deductions may continue to elect to deduct up to 100 percent of their AGI (formerly 60 percent prior to the CARES Act) for 2021 cash contributions to qualifying public charities. Deduction amounts above this AGI limit may be carried over for up to five tax years. The annual deduction limit for cash contributions by business donors also remains elevated in 2021 with corporations able to deduct up to 25 percent of taxable income (formerly 10 percent prior to the CARES Act).
For those individuals who take the standard deduction, the CARES Act continues to permit an additional “above-the-line” deduction of up to $300 in 2021 for cash charitable gifts. New in 2021 is an additional “above-the-line” deduction for married filing couples. Your jointly filing clients, who claim the standard deduction, are now permitted to take an above-the-line deduction of up to $600 in cash contributions to charity.
Charitable Donations from IRAs
Encourage your clients who are age 72 and older to direct up to $100,000 per year from their traditional IRA to a qualified charity, tax-free, to fulfill their annual required minimum distribution (RMD). Know that this qualified charitable distribution (QCD) strategy is appealing for clients who have few other deductions or are already close to their charitable deduction limitations.
Be wary that you cannot obtain a double tax break by taking a QCD and receiving an itemized deduction for a charitable gift. Unlike itemized charitable deductions, these QCDs lower the amount of modified adjusted gross income (MAGI) subject to taxation and can possibly help your clients avoid Medicare premium increases.
Plan ahead and run tax projections for clients who will use QCDs to save money. Donors can give funds to multiple charities with this technique. Advise your clients to notify their qualified tax preparer about QCDs because IRA custodians are not required to identify the transaction as QCDs on the annual 1099-R form, and it may be reported as an RMD.
Charitable Gifting Using IRA Distributions
Alternatively, if your clients are over age 59½ with an IRA, they can take an IRA distribution and use deductions for their charitable donations to help offset income tax liability on the withdrawals. Remember that this gift of cash to charity from an IRA distribution would fall under the new CARES Act cash deduction limit, permitting a donor to deduct up to 100 percent of AGI for the 2021 tax year.
As with QCDs, this strategy for clients between the ages of 59½ and 72 offers the added benefits of possibly reducing a donor’s taxable estate and minimizing tax liability for their account beneficiaries. It may also help clients who want to annually gift more than $100,000 in cash from their IRA and are limited by the QCD threshold. Think about utilizing this strategy for clients who are planning a large donation in 2021 and are not dependent on existing retirement funds to meet future cash flow needs.
Converting a portion of your clients’ traditional IRA assets into Roth IRAs in a year in which they make a large tax-deductible charitable contribution can be helpful in offsetting the taxes due to the Roth conversion. In effect, converting at a lower tax rate now may ensure many of your clients pay less tax than in the future, when the possibility of higher tax rates means more tax will be paid on IRA distributions.
Clients who can pay the income tax now on the Roth IRA conversion from non-IRA funds may also greatly benefit by enjoying higher investment returns from the Roth IRA “tax-free” asset class. Notably, there are no RMDs from a Roth IRA at age 72. Future withdrawals, after a five-year waiting period, are tax-free for Roth IRA owners who are age 59½ and older.
Ultimately, your clients can fulfill their philanthropic aspirations by donating to charities in need of their support. Direct your clients to the IRS’s online Tax-Exempt Organization Search1 tool to help them ascertain that an organization is tax-exempt and eligible to receive their tax-deductible charitable contributions.