If you didn’t catch this month’s office hours, you missed our discussion about common charitable giving strategies that our clients use to minimize taxes. No fear! You can catch the recording by clicking here. Or, read on to learn about the various charitable giving strategies we mentioned.
Before we discuss the four strategies, take a step back to ask yourself why you are giving to charity. Is it to lower taxes? If so, why are you trying to lower taxes? Generally, it’s because people want to increase their net worth or grow their worth. But think about it – giving away money to lower expenses isn’t exactly a wise strategy for growing your worth. If you give away $2.00 and it saves you $0.50 on your taxes, you still lost $1.50! We don’t generally give away money to increase our net worth, though. We give because we want to support a cause that we means something to us. We give because we are generous. We give because we like giving! With all of that said, there are a lot of tax rules and financial planning opportunities around how we give. So, if you give, consider structuring your giving to lower your tax bill – so you can give even more by giving away the tax savings, or so you can accomplish other goals with that tax savings.
Charitable Giving Strategy 1: Qualified Charitable Distribution
The first common strategy for giving to charity is through a Qualified Charitable Distribution (QCD). Here’s how a QCD works:
- Give away money to non-profit organizations from your Traditional IRA, and the distribution doesn’t increase taxable income.
- Satisfies a portion (or all) of that year’s Required Minimum Distribution (RMD)
- Donor must have attained age 70.5 at time of gift (not by year-end)
- Maximum QCD: $100,000 per year
- Tax benefit: Money that would have had come out of the IRA as part of an RMD is typically taxed, but if that RMD (or part of it) is given directly to charity, it is not taxable.
- Bottom line: If you are 70.5 years old or older and you already give to charity using your checking account, consider using your IRA instead.
Here’s a simple example of how this might work. Phil, a philanthropic fella, is 75 years old. His RMD from his IRA is $10,000. He typically gives away $4,000 to his church each year. He is in the 24% federal tax bracket and 6.85% state tax bracket. He takes the standard tax deduction as opposed to itemizing.
- Option 1: Have Flagstone send his $10,000 RMD to his checking account. He then writes a $4,000 check to his church.
- Tax effect: Federal and state income tax bill of $3,085 on the RMD. No tax deduction for the $4,000 contribution because he takes the standard deduction.
- Option 2: Have Flagstone send $6,000 from his IRA to his checking account, and $4,000 directly to his church.
- Tax effect: Federal and state income tax bill of $1,851. No tax deduction for the $4,000 contribution. Tax savings of $1,234.
This is an overly simplified example and there may be several variables that cause this not to play out like I wrote it. But the concept remains true – if you’re older than 70.5 years old, you might benefit by Qualified Charitable Distributions.
Charitable Giving Strategy 2: Gifting Appreciated Securities
The second common way to give to charity is by giving away appreciated securities. Under current law, you can gift appreciated assets and avoid paying capital gains tax on the unrealized gain. Here are the basics of how that strategy works:
- Give away appreciated securities in-kind to non-profit organizations
- You get credit for a charitable contribution equal to the market value of the security
- Tax benefit: You avoid paying tax on the growth of those securities
- Bottom line: If you own appreciated assets within a nonretirement (aka taxable) account, consider donating those securities in-kind to charities instead of donating cash, then repurchase those securities (or different securities) with cash.
Not only do you save money on the capital gains tax, but you can also give away more money to charity using the tax savings, which compounds your tax savings if you itemize deductions on your tax return. Schwab Charitable has a good example of how giving away appreciated securities can lower your taxes and help you give away more.
Charitable Giving Strategy 3: Donor Advised Funds
A third charitable giving strategy that might lead to a lower tax bill is a Donor Advised Fund (DAF). I wrote an article about the specifics of how donor advised funds work, which you can read about here. But here’s a shortened version of how these funds work:
- Contribute cash or appreciated securities to a Donor Advised Fund (DAF), which is a specific type of investment account.
- Get a charitable deduction in the year you make the contribution to the account
- Send money (called a “grant”) from the DAF to your favorite charities whenever you choose –right away, or years down the road.
- Tax advantage: You get a charitable deduction in the year you contribute to the DAF, but you can choose to actually donate the money to charity in future years. Therefore, many people choose to “lump”, “clump”, “stack”, “bunch” or “pre-fund” several years’ worth of giving into one year to maximize deductions, or to lower taxes in a year when income is irregularly high.
- Bottom line: If you are charitably inclined but don’t itemize, consider using a DAF to lump several years’ worth of contributions in one year so you can itemize in that year, then take the standard deduction in future years.
Charitable Giving Strategy 4: Beneficiary Designations
There are plenty of ways to minimize taxes during life by structuring your giving in specific ways. In addition to that, you can consider how to minimize taxes of those who are inherited your money after you die.
- Under current law, giving appreciated assets in a nonretirement account to heirs upon death will let them avoid having to pay taxes on any growth that has occurred. This is called getting a “step-up” in basis.
- Under current law, listing a charity as beneficiary on a Traditional IRA or other qualified retirement accounts (401(k), 403(b), etc) allows the charity to receive the funds tax-free. However, if a person inherits the Traditional IRA, they have to withdraw funds from the IRA within 10 years from inheriting, and they will have to pay tax on the withdrawals when they occur.
- Bottom line: It is typically more tax-advantageous for people to inherit nonretirement asset or Roth IRA assets than it is to inherit Traditional IRAs or other qualified retirement assets.
Here’s an overly simplified example of how being intentional about what assets you give to charity upon death might affect the taxes of other heirs. Generous Joe has a $500,000 Traditional IRA. He also has a $500,000 nonretirement account that has grown from an initial investment of $300,000. He has no other assets. He wants to give away half of his estate to charity when he dies, and give away the other half to his daughter.
- Option 1: List his daughter as beneficiary of the Traditional IRA, and the charity as the beneficiary of the nonretirement account. When he dies, the charity will receive the $500,000 from the nonretirement account tax-free. His daughter will receive the $500,000 Traditional IRA, chooses to put the money in an inherited IRA in her name, and has to take out all of the money from the IRA. She takes out $50,000 per year for 10 years, and pays $154,250 of ordinary income tax on those distributions over the course of 10 years.
- Option 2: List his daughter as the beneficiary on the nonretirement account, and the charity as beneficiary of the Traditional IRA. When he dies, the charity will receive the $500,000 Traditional IRA tax-free. His daughter will receive the $500,000 nonretirement account and will receive a step-up in basis. She will no have to pay tax on the growth that has occurred in the account, can liquidate the account, meaning she will effectively receive the funds without having to pay any ordinary income tax. She does pay a 1% inheritance tax since she lives in Nebraska. This option leads to a tax savings of $149,250.
Changing your beneficiary designations is a pretty serious change. You should consider talking to an estate planning attorney before doing something like that, because your estate plan typically relies on not just your will and potentially a trust, but also your beneficiary designations. Further, a qualified estate planning attorney can help you think through the tax effects of different beneficiaries on different accounts.
Not only should you consider talking to an estate planning attorney about a change like that, you should also consider talking to a tax professional and financial advisor about any of these strategies before pulling the trigger. There are a lot of technicalities that can make it easy to screw up, and your situation might be quite different than the examples that I laid out here, so please let us know if there’s a way we can help you think through these strategies. With that said, I hope you’ve learned a thing or two about ways to structure your giving in a way that makes the most sense from a tax standpoint.
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