Tax Efficient Charitable Giving
For some individuals, one of the most fulfilling aspects of building wealth is supporting organizations and causes that have had a meaningful impact in their lives. These individuals accomplish this through many ways including charitable gifting. Before gifting, closely consider your options and financial assets available as you could be leaving tax benefits on the table! Two potential tax savings techniques are Qualified Charitable Distributions (QCDs) from pre-tax retirement plans (SEP, SIMPLE, IRA, 401k, 403b) and Donor Advised Funds (DAFs).
With the passing of the SECURE Act new rules for Required Minimum Distributions (RMDs) became effective 1/1/20. Now individuals do not have to start withdraws from their pre-tax retirement accounts until the year they turn 72 (1). The SECURE Act also updated the Uniform Life Table to account for longer life expectancy resulting in lower required withdraw percentages (2). This provision will not take effect until 1/1/22. An individual turning 72 in 2022 would be required to take approximately 3.67% of their pre-tax retirement accounts out before April 1 of 2023 (3). All subsequent RMDs must be distributed by December 31st each year. You will want to make sure to meet this deadline otherwise you may face a penalty of 50% of the undistributed portion of your RMD! The withdraw “factor” in the updated table decreases every year resulting in a higher annual withdraw percentage (4.07% at 75, 4.96% at 80, 6.25% at 85).
One important provision in the SECURE Act that did not change is the age an individual may make a QCD from a pre-tax retirement account. An individual may still make a QCD starting in the calendar year they turn 70 ½ (4). For example, if a client does not turn 70 ½ until December they are still eligible to make a QCD anytime during the year.
A QCD is an effective technique that can potentially reduce federal tax liability while still accomplishing a charitable intent. This is implemented by taking a distribution from a pre-tax retirement account and sending the funds directly to organizations qualified under section 170 (c) of the Internal Revenue Code (nonprofits, Churches, Universities, etc.). Keep in mind that your children do not qualify as charities, although they may seem as such at times! By utilizing this technique, you may be entitled to claim an “above the line deduction” for the QCD. Above the line deductions are valuable tax planning tools that reduce your Adjusted Gross Income (AGI). An individual does not need to itemize his or her deductions to claim a QCD deduction.
For example, if a married couple files jointly (MFJ) with taxable income of $100,000 and makes a $5,000 QCD in 2021 they could potentially save $1,100 in federal income taxes. There is a limit to how much you can gift through a QCD, however. The annual limit is the lesser of $100,000 or your RMD (4). This limit is per individual, a married couple could potentially gift up to $200,000 annually via QCDs. Keep in mind that QCDs can only be utilized by individuals with retirement accounts over the age of 70 ½.
Another potential tax savings technique is contributing to a Donor Advised Fund (DAF). A DAF is an investment vehicle that an individual contributes cash or securities into in exchange for a potential below the line deduction. Once funds are donated, they can be invested and grow tax-free (5). These funds can grow for years and do not need to be distributed in a certain time frame. A donor can contribute now and wait to distribute the funds until he or she decides on which specific causes to support.
DAFs are useful for bunching charitable donations into one tax year to potentially receive a higher deduction. Bunching these contributions may be useful in years where an individual’s AGI is higher.
For example, an individual who just sold their business or received a large bonus may choose to contribute $50,000 in one year, rather than $5,000 over 10 years, to potentially receive a below the line deduction. An individual must itemize their deductions to deduct the contribution to a DAF. For the tax year 2021 an individual’s itemized deductions must exceed the standard deduction of $25,100 for Married Filing Jointly ($12,550 single). The amount of the charitable deduction is limited to 50% of AGI for cash donations and 30% of AGI for non-cash donations (Stocks, Bonds, ETFs, Mutual Funds etc.) (6). For additional tax benefits, consider donating highly appreciated securities to a DAF. This will allow the embedded capital gain to escape taxation.
For example, consider John & Mary’s situation:
- Mary, a retired Apple executive, has 500 shares of AAPL with basis of $2,000 and FMV of $60,000
- $200,000 AGI
If Mary decides to donate her 500 shares of AAPL to a DAF she could potentially claim a below the line deduction for $60,000 ($200,000 x 30%). If Mary had 1,000 shares of AAPL ($121,500) she would still be limited to a $60,000 deduction because of the 30% of AGI rule. If Mary only had 100 shares of AAPL she would not be eligible for the deduction as the MFJ standard deduction would be higher ($12,150 FMV vs. $25,100 standard deduction).
Before gifting, slow down and assess your assets, your tax situation, and seek professional guidance. As always, an individual should coordinate their gifting strategy with their accountant and financial advisor to maximize potential tax benefits.
(3) https://www.kitces.com/current-vs-new-uniform-lifetime-table-rmd-as-a-percentage-of-account-balance/
(4) https://www.fidelity.com/building-savings/learn-about-iras/required-minimum-distributions/qcds
(5) https://www.fidelitycharitable.org/guidance/philanthropy/what-is-a-donor-advised-fund.html