By Pete Snow
"Next to being shot at and missed, nothing is really quite as satisfying as an income tax refund." -- F. J. Raymond, humorist
The tax reform bill signed into law late last year, the Tax Cut and Jobs Act, provided sweeping changes to both the individual and corporate tax structure. Corporations received a significant decrease in the statutory tax rate, dropping it from 36% to 21%. Most individuals will see their tax rate drop, albeit by a smaller amount. Although there are still seven tax brackets, just as in 2017, the tax rates in five of the seven brackets were reduced. In some cases, the rate was reduced by as much as 4%. In addition to the tax rates being reduced, the breadth of the tax brackets was expanded, adding to the tax relief because the lower tax brackets will now include more filers.
In addition to the changes to tax brackets, tax reform changed other aspects of the tax code, including the standard deduction and personal exemptions. Both a deduction and an exemption will reduce your taxable income and lower your income tax. Filers choose between the standard deduction, which everyone is eligible for, or the itemized deduction. The itemized deductions comprise the sum of certain eligible expenses such as real estate tax, state and local tax, and charitable gifts.
A filer will choose between the standard deduction (which was $12,700 in 2017) or the itemized deduction, whichever is greater. In 2017, the personal exemption was $4,050 and you are granted one exemption for yourself, your spouse, and eligible dependents. When adding the personal exemption, a married couple filing jointly could shelter $20,800 from taxes.
In 2017 it was not uncommon for a taxpayer to exceed the standard deduction by virtue of the interest paid on their mortgage and state taxes paid. This would lead many to use the itemized deduction. In this scenario, any gifts made to charity would be deductible, and that deduction would help reduce your tax liability for the year. For example, if a family that itemizes their deductions gave $10,000 to a charity, their taxable income would be reduced by the same amount. Assuming they are in a 28% federal tax bracket, they may save $2,800 on taxes that year. People that give money to charity do it to support a cause that is important to them, so the tax break is just an ancillary benefit, but a benefit just the same.
With the passing of the Tax Cut and Jobs Act, the standard deduction has nearly doubled to $24,000 for a married couple, and the personal exemption was eliminated. The implication to those who are charitably inclined is that the threshold that must be reached before charitable gifts become deductible has increased substantially.
Most people give without regard to the tax implications, but with careful planning, you can make a gift and also receive a nice tax break while doing so. A tool that has been rising in popularity over recent years is something called the donor-advised fund. A donor-advised fund is simply an investment account that is created by an individual that wants to give assets to a charity at a future date. Think of it as a dramatically simplified foundation. Accounts can be opened at many financial institutions including Schwab Charitable, Fidelity Charitable, and Vanguard Charitable. Once opened, the account may be funded with cash or appreciated securities. The money stays in the account until the donor chooses to disperse the money to the charity of their choice. While the money is in the account, the donor can choose among a variety of investment options to help the assets grow. At lower asset levels, the donor may have between five and 10 investment choices. At higher asset levels, the donor may be able to have the money managed by the investment professional of their choice.
Giving to your favorite charity from the donor-advised fund is also quite simple. The grantor, or account owner, can recommend a grant to the charity of their choice. Nearly any IRS-qualified 501(c)(3) charity is eligible to receive a gift. To find out if your charity is IRS qualified, a good resource is Guidestar or Charity Navigator. Gifts may start as low as $50, depending on the financial institution you chose for your donor-advised fund.
What makes the donor-advised fund unique, and why it affords us a tax planning strategy, is that the contribution is recognized when the account is funded, even if the money is not distributed to the charity in the current year. This allows the donor to take a deduction today for a gift that will be made in subsequent years.
Donor-advised funds can be funded with cash, but also with appreciated securities. Appreciated assets with a low cost basis are great candidates to contribute to a donor-advised fund (such as stocks or mutual funds that have experienced a significant gain). You could sell these securities and give the proceeds to a charity as cash, but the capital gain that you would realize may cause your tax liability to increase. Conversely, you could contribute these appreciated securities to a charitable organization or transfer them to a donor-advised fund. The donor would recognize a deduction equal to the current market value of the securities, which may cause their tax liability to decrease.
To illustrate how a donor-advised fund may be used as a tax planning tool, consider the following situation: in 2018 a married couple that anticipates itemized deductions of $20,000 ($10,000 of which is from charitable gifts) would opt for the standard deduction of $24,000. If their circumstances remain the same for the next two years, they would have used the standard deduction each year for a total of $72,000 in deductions.
Using a donor-advised fund may allow them to increase their deductions, while giving the same amount each year. Perhaps the couple had some appreciated assets (stocks or mutual funds) that they did not need for living expenses. In addition to their current annual gift of $10,000, they could consider putting $20,000 of appreciated stock in a donor-advised fund. The $20,000 would represent their charitable gifts for 2019 and 2020. Doing this would cause this year's itemized deduction to increase by $20,000. Using this strategy would allow them to realize deductions of $40,000 in 2018, $24,000 in 2019, and $24,000 in 2020 for a total of $88,000. This is $16,000 more than simply accepting the standard deduction for the same three-year period, and they would do so while giving the same amount. That additional deduction they captured may amount to $4,480 in tax savings over the three-year period, or an amount equal to about half of annual gift. This is achieved through simple planning and timing.
This technique also works well if you have a year of unusually high income. Perhaps you sold a business, exercised stock options, or received a large bonus at work. Front loading a donor-advised fund can allow you to reduce taxes in the current year and maintain your charitable giving strategy in subsequent years.
Another way this strategy is put to good use is in the past few years of your career. At this stage of life, you are likely in your peak earning years, a high tax bracket, and deductions are likely harder to come by. Opening a donor-advised fund gives you the opportunity to take the deduction while you are in a high tax bracket, and give the money away during your retirement years when you are likely in a lower tax bracket and deductions are less valuable.
If charitable giving is part of your financial plan, a donor-advised fund may be a great tool for your consideration. Giving is done to benefit a charity close to you, but careful planning may allow you to increase your giving, make your giving strategy more sustainable, and perhaps save some money in taxes along the way.
To see if these strategies may be a good fit for you, be sure to consult your tax professional or financial planner. To learn more about the financial planning profession, consult www.onefpa.org. To find a planner in your area, visit the CFP® Board of Standards website.
About the author: Pete Snow, CFP©, MBA, is the Director of Investment Research and Senior Investment Advisor at NFP in Plymouth, Minn. and is a member of the Financial Planning Association of Minnesota. He can be reached directly with questions at firstname.lastname@example.org.