A Legacy That Lasts

PAUL HANSEN

This article previously appeared in our self-published “End-of-Life Planning Guide.”

Inside this guide, you will find articles written by funeral planning, legal, wealth management, hospice, and insurance industry experts to give you a better understanding of how to best plan for your finances and the legacy you will leave behind once you have passed. Also included are complimentary planning worksheets that will act as aids to simplify the process of creating your end-of-life financial plan.

To learn more about this guide and receive a free digital copy, visit this page to download now.

 

Techniques for making tax efficient charitable donations both during and after your lifetime.

If you are currently making annual donations to your favorite non-profit organizations, or if you want to make sure that a portion of your estate transfers to them when you pass away, here are three tax-efficient strategies that you should consider.

  • Gifting appreciated securities rather than cash
  • Making Qualified Charitable Contributions from pre-tax retirement account
  • Naming the charity as a beneficiary of your pre-tax retirement account

 

Tax Efficient Donations During Lifetime

Many of my clients find it very rewarding to give to their favorite charities while they are alive.  Not only do the non-profit organizations greatly appreciate the year-to-year cash flow that it provides, but I can tell that my clients enjoy getting to see the impact that their donation makes.  As an advisor, my goal is to help my clients achieve their charitable goals in the most tax efficient way possible.  For example, you could write a $10,000 check to a non-profit organization and get no tax benefit for it, but wouldn’t it be better if you could make a $10,000 donation and save over $2,000 of tax at the same time?  Even if you’re not concerned about saving the $2,000 of tax for yourself, maybe this would allow you to donate $12,000 in a way that only costs you $10,000 after tax.  Here are my three favorite methods for tax efficient donations during your lifetime:

 

GIFTING APPRECIATED SECURITIES (MUTUAL FUNDS, STOCKS, ETC.) FROM YOUR INVESTMENT ACCOUNT

If you gift securities from a non-retirement investment account directly to a non-profit organization, rather than selling the securities and donating the cash proceeds, you potentially get two tax benefits rather than just one.  For example, if you purchased mutual funds for $4,000 in the past, and those mutual funds are now worth $10,000, you can avoid paying any tax on that gain by transferring those mutual funds from your investment account to the non-profit organization’s investment account, rather than selling the funds and donating the cash.  Here’s why – if you sell the funds for $10,000 it creates $6,000 of taxable gain to you ($10,000 less your original cost of $4,000) and, if you have enough other taxable income sources that year, you will probably pay $900 of “capital gains” tax as a result (15% x $6,000).  Alternatively, if you transfer ownership of the mutual funds (without selling them) to the non-profit organization, you don’t have to pay any tax on the $6,000 of gain.  This is a $900 tax savings by making the same donation in a slightly different way.

 

MAKING QUALIFIED CHARITABLE DISTRIBUTIONS FROM A RETIREMENT ACCOUNT

This is an excellent tax saving strategy if you currently take the standard deduction on your tax return rather than itemizing.  If you have a pre-tax retirement account such as an IRA or a 401k, and you are at least 70½ years old, then you can make up to $100,000 of annual donations directly from your retirement account to your favorite charity without having to pay the income tax that usually results from taking retirement account distributions.  This type of distribution is called a Qualified Charitable Distribution, or QCD for short.  In order to obtain the tax benefit, you must follow certain rules without exception

  • You must be age 70½ or older on the date that you make the donation
  • The distribution from the account must be a check made payable to the non-profit (not to you)
  • Your combined total of QCDs to all charities cannot exceed $100,000 per year
  • You cannot claim the QCD amount as an itemized deduction (that would be double counting)

If you are age 72 or older, and you are required to take Required Minimum Distributions (RMDs) from your retirement accounts each year, you can satisfy some or all of your RMD by sending funds directly to a charity through the QCD process.  This is a great option for retirees who are forced to take RMDs every year, but they don’t need those funds to cover their living costs because they have other income sources (Social Security, a pension, etc.).  The reason this is such a tax efficient way to give is because any personal withdrawals from your pre-tax retirement accounts are taxed each year, but distributions in the form of a QCD are not taxed.  For example, if you are in the 22% tax bracket and want to donate $10,000 to a charity, you could take $10,000 from your IRA, put it in your checking account, and then write a $10,000 check to the charity, but you would owe $2,200 of tax on the income at the end of the year.  Alternatively, if you made a $10,000 QCD directly from your IRA to the charity, you wouldn’t owe any tax on the distribution.

You have achieved the same goal of making a $10,000 donation, but you saved yourself $2,200 of tax by using the QCD process.

 

Tax Efficient Donations At Death

NAMING A NON-PROFIT ENTITY AS A BENEFICIARY OF YOUR RETIREMENT ACCOUNT

If your estate is likely to include a pre-tax retirement account like an IRA or 401k when you pass away, and you want to make sure that a portion of your estate goes to your favorite charity, then you should strongly consider naming the charity as a beneficiary of your retirement account instead of gifting assets to the charity through your will.  Before explaining the tax benefit, it’s important to understand that there are certain assets you own that typically are not distributed based on your will because you name the beneficiaries of these assets separately and they do not go through the probate process that distributes all of your other assets based on what is written in your will.  Retirement accounts and life insurance policies are two of the most common assets that have their own beneficiary designations.  For this reason, it is important that you know who is listed as a beneficiary of your retirement account, and make changes while you are alive if the current beneficiaries no longer match your wishes.

From a tax perspective, your heirs will generally inherit the assets governed by your will, and any life insurance proceeds, without personally owing any income tax as a result.  Additionally, under Federal law, even if you would have owed capital gains tax on the sale of these assets during your lifetime (because you sold them at a higher price than you originally bought them for), your heirs could immediately sell these assets and pay no tax on the gain.  Unfortunately, this is not true for inherited pre-tax retirement accounts.  Not only will your heirs pay income tax on every dollar they withdraw from the retirement account, but the IRS is going to require that they take all of the money out of the account (and pay tax on the income) within 10 years of inheriting the account unless they are your spouse or qualify for an exception to the rule.  For this reason, if a person could choose between inheriting a home valued at $300,000 or a pre-tax IRA valued at $300,000, they would definitely choose the home because they could immediately sell it and owe no tax, rather than withdrawing money from the IRA and paying income tax on it.  Here’s the good news…non-profit charities don’t pay taxes on assets that are donated to them.  For a charity, receiving a gift of a $300,000 house or a $300,000 IRA is the same financial benefit (though they would definitely rather have the IRA so that they don’t have to deal with selling the house).

The following is a simplified illustration to show how this works.

You have decided that you want to contribute $100,000 to your favorite charity when you pass away, with everything else going to your children.  At the time of your death, your estate consists of the following assets that total $600,000

  • $100,000 pre-tax IRA
  • $25,000 cash in bank
  • $75,000 investment account
  • $350,000 home
  • $50,000 other assets

 

Option 1 – your Will says that $100,000 will go to charity and the remainder will go to your children.  Additionally, your children are listed as the beneficiaries of your pre-tax IRA

The result of this option is that the pre-tax IRA will eventually become taxable income to your children.  None of the other assets will be taxed to your children, and the donation to charity will come out of non-IRA assets and will have limited or no tax benefit to your estate or to your children

 

Option 2 – your Will gives everything to your children, but you filled out paperwork with your advisor to list the charity as the 100% beneficiary of your pre-tax IRA

In this case, the charity still receives a $100,000 donation, but this time your children will not have to pay taxes on any of their inheritance because they didn’t receive the IRA.  If your children are in the 22% tax bracket, this option would save them $22,000 of tax that they would have paid on the IRA proceeds.

In summary, with just a little bit of planning, you might be able to save a considerable amount of tax for you or your heirs by utilizing one of these tax efficient giving strategies.  While the overall concepts are straight forward, I strongly recommend that you work with a Certified Financial Planner, CPA or Attorney to make sure that the strategy will work under your specific circumstances.

 

Still have questions on how to best maximize your charitable contributions to your favorite cause or organization?

Schedule a time to talk with the author of this blog and HFG Trust Financial Advisor, Paul Hansen, CPA, CFP®.

 

PAUL HANSEN, CPA, CFP®

Financial Advisor, HFG Trust