Smart Charitable Planning: Tax Efficiencies While Doing Good
Even before the pandemic sent shockwaves through the economy, higher-income earners were directing their attention to charitable planning strategies that offer a double win: They help to improve the world, and provide a tax break for donors.
Since the onset of COVID-19, this trend has accelerated. In fact, since March, when the public health crisis put the brakes on much of the economy, donors have given at a record-setting pace. According to a June 26, 2020 article in The New York Times, the pandemic has significantly accelerated philanthropy – with people giving more and giving it faster than they typically do.
The need for charitable giving, especially purposeful gifts that help to make an impact, will undoubtedly continue long after the coronavirus pandemic is contained. But smart planning can help taxpayers to support the charities important to them now, or over time, while providing tax-efficient, and in some cases, tax-free benefits.
Read more about Bunching Donations, Donor-Advised Funds, Qualified Charitable Contributions, and Designating Charitable Beneficiaries below…
Bunching involves consolidating— into a single tax year—those tax-deductible charitable contributions that normally would be made over several years. The 2017 Tax Cuts and Jobs Act (TCJA) put a cap of $10,000 on itemized deductions of state and local income and real estate taxes, which forced many taxpayers to opt for the better standard deduction. But high net-worth taxpayers who combine or “bunch” donations for multiple years of normal annual charitable contributions into a single year will increase the prospect of exceeding the new, higher standard deduction, ($24,800 for married people filing jointly in 2020).
In the “bunched” contributions year, the donor contributes to a charitable giving tool, such as a Donor-Advised Fund (DAF), and receives an immediate tax deduction by itemizing deductions on their federal tax return. In succeeding years, the donor then recommends grants from the DAF; this allows the taxpayer to use the now higher standard deduction in those years.
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Simply stated, a Donor-Advised Fund (DAF) is like a charitable investment account. Its sole purpose is to support the IRS-qualified charities you care about – whether it’s a local food bank, a medical institution or your alma mater. Contributions of cash, stocks, private investments—and even cryptocurrency—are eligible for an immediate tax deduction. A variety of sponsoring organizations, from national financial services firms to local community foundations, offer donor-advised funds, with a range of investment options to choose from. Since the donor decides when the assets will actually go to the charity, these assets can potentially grow tax-free—making even more money available to donate to charities.
It’s important to remember that contributions to a DAF are an irreversible obligation; the funds cannot be returned to the donor or any other individual, nor can they be used for any purpose other than making grants to charities.
Because the timing of DAF contributions is not tied to the actual contribution to a designated charity, the most common reason for using this strategy is to “front load” charitable contributions in a high-income year when the tax-deduction threshold for charitable contributions will be higher. This may be the result of cash flow events ranging from selling a business to receiving deferred compensation. The DAF can be used to make succeeding contributions to the charity in future years. This strategy enables the donor to maximize the value of the tax deduction in a high-income year, and also keep the flexibility to decide which charities the funds will actually go to in future years.
Other good reasons for using a Donor-Advised Fund include the ability to give anonymously, as well as create an “In Memoriam” fund. Some donors don’t want to be attached to the gift for donor recognition purposes or because they might be sought out by other charities. The ultimate distribution is made by the organization sponsoring the DAF, and it is not required to disclose the source. Another benefit for using a DAF is that some families find it is a less costly alternative to a private foundation. Moreover, it offers the whole family the chance to participate in charity-granting decisions, possibly even teaching responsible giving habits to children.
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Qualified Charitable Contributions
A Qualified Charitable Distribution (QCD) is a withdrawal from an individual retirement account (IRA) that is made directly to an eligible charity.
While it might seem odd to want to give away one’s savings after years of contributing toward eventual retirement, this strategy can offer important tax advantages to older taxpayers. That’s because upon reaching 72, taxpayers must begin taking required minimum distributions (RMDs) even if they don’t want or need the money. These distributions are taxable at ordinary income rates, and in most cases there’s a 50% excise tax on whatever distributions the owner was supposed to take, but did not.
For 2020, however, the CARES Act is waiving all RMDs, so older taxpayers may leave their IRA funds alone if they wish. In 2021, the new age requirement of 72, set by the SECURE Act of 2019, will take effect. Previously, the required beginning date for RMD holders of IRAs was 70-1/2.
QCDs count toward the taxpayer’s RMD for the year, so they are a good way to distribute the minimum required amount out of the IRA – and avoid the 50% excise tax penalty. In addition, the distribution is not taxable, unlike funds withdrawn for personal use.
In addition, QCDs enable individuals to fulfill their required minimum distribution by a direct transfer of up to $100,000 to charity. This strategy also can be used for multiple charities, as long as the total of the distributions is within the $100,000 limit. For married couples, each spouse can make QCDs up to the $100,000 limit for a potential total of $200,000.
QCDs have other advantages, as well. For example, because they reduce the balance of the IRA, they may reduce RMDs in future years. In addition, they aren’t counted toward the maximum deductible amounts for those who itemize their giving on their taxes. As a result, the donor is potentially able to give a larger charitable gift than if they just donated cash or other assets.
Qualified Charitable Distributions are made directly to the IRS-qualified charity from a traditional IRA, inherited IRA (if owner is over 72), inactive Simplified Employee Pension (SEP) plan and inactive Savings Incentive Match Plan for Employees (SIMPLE) IRAs. The money is transferred directly, either by the IRA custodian who sends a check directly to the charity or to the account owner, who then presents it to the charity.
Before proceeding with a QCD, it’s important to confirm that the organization is qualified to receive it. At present, QCDs cannot be made to Donor-Advised Fund sponsors, private foundations and supporting organizations, even though they are considered charities.
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Designating Charitable Beneficiaries
Beneficiaries generally don’t have to pay income tax on money or other property they inherit, with the usual exception of money withdrawn from an inherited retirement account (IRA or 401(k)). That’s because tax-deferred retirement plans, such as a conventional IRA and 401(k), are generally not taxed before the money is put in. Income tax on the funds is deferred until money is withdrawn from the account, either by the original contributor or by the person who inherits the account.
A beneficiary who withdraws money from an inherited retirement account must report that money as ordinary income. The tax will be due with the person’s regular annual income tax returns, both state and federal. The exception is money that a beneficiary withdrew from a Roth-type plan; since Roth accounts are funded with money that was already taxed, the accounts are treated like other inherited property.
Surviving spouses who inherit a retirement account can defer the tax by rolling over the account into a retirement account of their own. Other beneficiaries can change the account into an “inherited IRA” and withdraw the money over several years, spreading out the income tax as well.
For most non-spouse beneficiaries, the 2019 SECURE Act stepped up distributions from their life expectancy to a 10-year payout. As a result, it could be worthwhile exploring the feasibility of designating a charitable beneficiary. When an exempt charity is named as the beneficiary of the retirement account, that charity will receive both income and estate tax charitable deductions.
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How REDW Wealth Can Help
With the greater need for charitable giving in these difficult times, this may be a good time to review your or your family’s philanthropic plans. The experienced team at REDW Wealth is ready to answer your questions or help you develop a plan that aligns with your charitable interests and concerns.