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Bunching Tax Strategy - Charitable Donations to Reduce Taxes
- By Travis Echols
- •
- 03 Jun, 2019
Updated on January 7, 2020.
No matter their political persuasion, I’ve never yet met a person who wanted to overpay the IRS. It's no wonder. Taxes paid to the federal government are usually the biggest single expense people have during their working years and in retirement. Below are some bunching tax strategy plans wen it comes to charitable donations.
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The Importance and Rarity of Tax Planning
Surprisingly, many financial planners do not do tax planning for their clients. Their disclaimers state such. Whether due to lack of knowledge, overzealous compliance, or assuming their clients’ tax preparers are doing tax planning, for many retirees, it just doesn’t get done. And as a result, lots of opportunities are missed and strategic mistakes are made.
Tax preparing looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning
on the other hand looks at taxes in the context of your overall financial
picture. A tax planner not only looks in the rear-view mirror to the last year;
he will look forward
20 to 30 years at your projected
tax liability and ask what can be done to lower your lifetime
tax bill.
The legendary CPA Ed Slott quips “to make clients money through investments and yet omit tax planning for distributions is like playing the first half of the game and sitting out the second half.” Even if you are great at accumulating assets, what good is it if you lose it through unnecessary taxes.
A financial adviser who does tax planning will coordinate tax reduction strategies with you and your tax preparer. This team approach to financial planning helps you implement the most effective tax strategies for your situation.
Some Tax Basics
For some tax basics, here are the four main categories of how to lower your taxes:
1. Tax avoidance -
excluding income (such as municipal bond interest) and deducting expenses (such as
mortgage interest and charitable donations)
2. Tax deferral - postponing paying taxes until your tax rates will be lower (such as traditional IRAs and 401ks)
3. Conversion- converting short-term capital gains into long-term capital gains
(which is a lower tax rate than your marginal rate)
4. Income shifting - transferring income-producing assets to someone in a lower
tax bracket
- Step 1: Add up your total
income. This is line 6 of the new Form 1040.
- Step 2: Subtract adjustments from total income to get adjusted gross income (AGI). This is line 7.
- Step 3: Combine itemized deductions to discover if they exceed the
standard deduction amount. (Schedule A for itemized deductions)
- Step 4: Calculate taxable income
by subtracting the greater of itemized deductions
or the standard deduction amount from adjusted gross income. This is line 10.
- Step 5: Determine tax from either the tax table or the tax rate
schedules, depending on which applies.
- Step 6: Subtract nonrefundable credits, if any, from the tax found in
Step 5 and add other taxes to determine net tax liability.
- Step 7: Subtract payments and refundable credits to determine amount owed or refundable.
Granted, there are many things about taxes over which we have no control, but the things we do
have control over
can make a huge difference. The tax strategy I'll show you in this article will focus on taking full legal advantage of step 4 of the process.
Challenges of the Tax Cuts and Jobs Act of 2017
As I wrote in “Highlights from the New 2018 Tax Rules”, The Tax Cuts and Jobs Act of 2017 (TCJA) doubled the standard deduction. Here are the updated 2020 standard deductions, which have increased slightly from 2019.
Figure 1. 2020 Standard Deduction tax figures
As a result of TCJA’s raising of the standard deduction and new limitations placed on certain deductions (like the $10,000 maximum State and Local Tax deduction), an even greater majority of households today find that their itemized deductions are lower than the standard deduction; so, it makes sense to claim the standard deduction.
But that means that all the
expenses which qualify as itemized
deductions (e. g., state and local taxes, mortgage interest, charitable giving)
count for nothing toward reducing your tax bill (for those of you who claim the standard deduction).
Getting Creative Using Your Charitable Gifts
Wouldn’t it be great if you could claim the higher standard deduction and still lower your taxes by using some of those "deductions"? That would be a win-win.
One item that particularly lends itself to some creative tax planning for retirees is charitable giving.
If you are already giving to charity, the question is how you can get some tax relief from your donations. (Note: Though you can financially help others through giving, you can't "directly" increase your own net worth by giving more to charity. But you may directly increase your net worth and help others if you carefully plan how you give.)
One great win-win strategy for people age 70½ or older who own retirement accounts is to use a Qualified Charitable Distribution (QCD). This donation is an above-the-line deduction (adjustment) that lowers your AGI (Step 2 in the process above), which can be even more tax advantageous than an itemized deduction (Step 4). See my article, “How to Reduce Your Taxes on Your IRA RMD using QCD.”
However, for taxpayers not yet 70½, or their RMDs are not as large as their donations, there is another win-win strategy that involves “bunching” itemized deductions. The idea here is to alternate between claiming the standard deduction some years and itemizing deductions other years.
For example, if you itemize deductions this year (2020) and claim the standard deduction the next year (2021), you can make two years of charitable contributions this year, but none in the following year. This is possible because you are in control of how much and when you give. Other deductions are not so flexible, although non-urgent medical expenses can sometimes be lumped into a single year to clear the 7.5% of AGI threshold (2020).
Let’s look at
an example below using charitable contributions to reduce taxes over a
three-year period.
Figure 2. Example of Bunching Charitable Contributions
Let's say hypothetical couple Roy and Renee Jones claim itemized deductions of $34,800 in 2020 (which is well above the standard deduction of $24,800). It makes sense to itemize because they are bunching three years of their normal $5000/year charitable contributions into year 2020.
This front-loaded $15,000 donation in 2020 could be made payable to
- their charity or charities directly, or
- a Donor Advised Fund that allows the Jones to claim the deduction in 2019 but direct the distribution from the donor-advised fund to their charities over time. See my article, "How to Reduce Your Taxes Using a Donor Advised Fund."
The Jones will then not make any charitable contributions the next two years, since they gave them in 2020. Then in 2021 and 2022, they can claim the standard deduction.
In this example, the Jones' total deductions for three years are $84,400. Had they not bunched deductions in 2020, and instead simply claimed the standard deduction for all three years, their charitable donations would not have helped lower their taxes at all. As a result, the Jones' total deductions would have been only $74,400 ($24,800 x 3). This strategy allowed Roy and Renee to deduct an extra $10,000 ($84,400 -$74,400). In the 32% tax rate this would save them over $3000.
By repeating this process, they could save tens of thousands of dollars over their lifetimes!
Unless you want to give the IRS a big tip, bunching charitable contributions could be a win-win-win for you, your family, and the cause you believe in.
Deduction Limits
There are some limitations the IRS places on these deductions. For gifts of cash to a public organizations such as churches, schools and hospitals, the maximum current year deduction is limited to 60% of your Adjusted Gross Income (AGI).
The limitation is only 30% of AGI for long-term capital gain (LTCG) property (if the deduction is based on the fair market value of the property) to a public charity. If you gift short-term capital gain (STCG) property (held less than one year), you can only deduct your cost basis, not the fair market value. Figure 3 below illustrates.
Figure 3. Deductions by Type of Property and Organization
50% Election
On a long term gain property, you want to also consider the "50% election" (which uses your basis) versus the 30% of AGI method which uses Fair Market Value (FMV). The 50% election may be best if the property is not highly appreciated (i.e., the difference between the FMV and your basis is relatively small). The 50% election may also be advantageous when you are in a higher marginal income tax bracket now than in future carry-forward years. Using the 50% election could result in the biggest lifetime tax savings.
For example. Karen has an AGI of $140,000 this year. She owns stock with a fair market value (FMV) of $82,000 and a basis of $75,000. She has owned the stock for five years. She wants to donate the stock to her church instead of making cash donations. If she chooses the 50% election, she would use the basis of the stock ($75,000), and her current-year deduction would be limited to 50% of her AGI ($70,000), with a $5,000 carry-forward.
If, instead, she uses the FMV of the stock ($82,000), her deduction this year is limited to 30% of her AGI ($42,000) with a carry-forward of $40,000 (82,000 minus 42,000).
As you can see, with the 50% election, Karen has a larger current-year deduction, even though using the FMV provides her a greater deduction over several years. If Karen knows her marginal tax rate will be much lower after this year, the 50% election could be the better option.
Other Charitable Giving Issues to Consider
Charitable Giving to Reduce Taxes (Final Thoughts)
Gifting highly appreciated long-term property such as stocks in a taxable account can be a double-win in that you get the deduction and you avoid the potential long-term gain tax.
Just remember though, charitable gifts are itemized deductions (except for QCDs) and won't help you if you use the standard deduction. That is why alternating between standard and itemizing front-loaded bunched deductions can be such a tremendous tax advantage for those who are charitably-minded and plan ahead.
This is just one of many tax saving strategies you should consider. For other strategies, read my articles:
“Leverage Tax-Efficient Withdrawal Strategies to Boost Your Retirement Income”,
“How to Maximize the Roth IRA to Your Tax Advantage”,
“How to Dodge the Social Security Tax Torpedo”, and
“How to Reduce Your Taxes on Your IRA RMD.
As always, the tax strategies described here are not to be taken as advice to you. They are strategies to discuss and coordinate with your financial adviser and tax preparer.
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
Sign up to receive my free monthly email articles...because you want to make the most out of your retirement
.
Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
Sign up to receive my free monthly email articles...because you want to make the most out of your retirement
.
Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
Sign up to receive other helpful email articles on retirement planning--free of charge
.
If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
.
So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
Serving Cumming, GA, Forsyth County, and the surrounding areas of John's Creek, Alpharetta, Milton, Duluth, Buford, Suwanee, Flowery Branch, and Gainesville
