Tax changes that went into effect in 2013 raised the income tax rate for high-income earners, making charitable deductions a more attractive option. With careful planning, a year-end gift may allow you to do more for others than you might have anticipated and still improve your own position, both today and tomorrow. Charitable contribution deductions on your current income tax return and capital gains tax savings are of foremost benefit. Future estate tax savings may also result from charitable giving strategies.
When should you give? For those who itemize deductions, a gift made before Jan. 1 is deductible in the year in which it is made. If you have taken the standard deduction in the past, a gift in the appropriate amount may increase your deductions above the standard. This qualifies you for a greater tax benefit.
What should you give? Fidelity Investments suggests four tax-savvy strategies to help you make the most of your giving this year.
Give appreciated securities rather than cash. The donation of cash or check is, by far, the most common method of charitable giving. Cash donations, however, are generally not the most tax-efficient method to give. Contributing stocks, bonds, or mutual funds which have appreciated over time is becoming increasingly popular, for good reasons. Most publicly traded securities with unrealized long-term gains (meaning they were purchased over a year ago and have increased in value) may be donated to a public charity and the donor can claim the fair market value (up to 30 percent of the donor’s adjusted gross income) as an itemized deduction on his or her federal tax return. Other types of securities, such as restricted or privately traded securities and donations to non-public charities, may also be deductible, but additional requirements and limitations may apply. No capital gains taxes are owed, because the securities are donated and not sold. The greater the appreciation, the bigger the tax savings will be.
Consider establishing a donor-advised fund. With charities which have donor-advised fund (DAF) programs, you can make irrevocable contributions to the charity, which establishes a DAF on your behalf. A range of public charities sponsor donor-advised funds. You can then recommend grants to other eligible charities — generally speaking, IRS-qualified 501(c)(3) public charities — from your DAF.
Establishing a donor-advised fund may be a particularly useful strategy at year-end because it allows you to make a gift and take the tax deduction, immediately, but also take your time to decide where the dollars will go. It can be a great way to offset a year with unexpectedly high earnings, or address the tax implications of year-end bonuses.
Consider using a charitable donation to offset the tax costs of converting a traditional IRA to a Roth IRA. Even with higher income tax rates, many investors are considering converting from a traditional IRA to a Roth IRA. In addition, the American Taxpayer Relief Act made it possible for active employees to convert a 401(k), 403(b) or 457(b) plan account to its Roth counterpart within the same plan.
The most essential difference between traditional retirement savings vehicles (whether they’re IRAs or workplace plans) and the Roth versions is, with the former, contributions are usually tax deductible in the year they are made and can grow tax deferred within the account; the contributions and earnings are then taxed at “the back end” (i.e., upon withdrawal). With a Roth, contributions are not tax deductible, but are included in income and subject to income taxes. Withdrawals from a Roth are tax free. Roth accounts, generally, make sense if you believe your current tax rate will be lower than in the years you’ll make withdrawals.
Keep in mind, when you convert a traditional retirement savings account into a Roth, you will owe taxes on any pre-tax monies converted. Depending on the amount converted and your tax rate, the taxes on the conversion can be significant. It’s generally unwise to pay these taxes out of the retirement account being converted, as doing so would reduce your retirement savings and the account’s growth potential.
Converting in a year in which you can claim a large tax deduction, such as a charitable deduction, can be helpful in offsetting the conversion taxes. While your total out-of-pocket cost will be higher, this is still an opportunity to give to charity while reducing your taxes.
Consider donating complex assets. Donors may also contribute complex assets — private company stock, restricted stock, real estate, alternative investments or other personal property — directly to charity. The process requires more time and effort than the gifting of cash or publicly traded securities, but has distinct advantages.
These types of assets often have a relatively low cost basis. In fact, for entrepreneurs who have founded their own companies, the cost basis of their private C Corp. or S Corp. stock may be zero. In cases where these assets have been held for at least a year, the outright sale of the asset would result in a large capital gains tax for the owner. If, however, the asset is donated directly to a charity and the charity then sells the asset, the original owner is in many cases able to eliminate capital gains taxes on the sale of the assets, while potentially receiving a charitable donation deduction as well.
Another option to consider is a gift of real estate or life insurance. Selling real estate could result in a sizable capital gains tax. Almost any real estate, developed or undeveloped, is potentially a charitable gift. If you’ve owned your home or other real estate for a long time, it has likely increased in value. Consider donating the property or placing it in a trust. You’ll avoid the tax and realize a charitable deduction for the full fair market value of the property.
Your life insurance policy can be a great tool for charitable giving. Policies which are paid in full may be deductible as gifts for their replacement value (unless that value is greater than the tax or cost basis).
Policies which still require premiums to be paid can be given and the future premiums are deducted from annual income tax. You may qualify for income tax deductions when the organization receiving the policy is named as owner and beneficiary. According to Investopedia, there are various types of life insurance donations.
Charitable Giving Riders. Charitable giving riders are a relatively new. For example, these riders can be attached to policies with face values of more than $1 million and then pay an additional 1 to 2 percent of the policy’s face value to a qualified charity of the policyholder’s choice. There are, at times, limitations placed on the maximum allowable gift amount. Furthermore, these riders usually come at no additional cost and often do not increase the premium or reduce the cash value or death benefit of the policy. These riders effectively eliminate the need to create, pay for, and administrate separate gift trusts until the death of the insured.
Once the rider has been added, no further action is needed by the policyholder. These riders do have a few limitations, perhaps the largest of which is the high amount of protection which must be purchased in order to use them. Any charity chosen must also be a qualified 501(c)(3) charity which meets the IRS definition of a nonprofit organization. Furthermore, make sure the charity will actually accept your life insurance policy. Some types of policies, such as term policies, are often shunned by these organizations.
Policy Donations. Although this strategy is a bit more involved than merely purchasing a charitable gift rider, policy donations also provide a much greater benefit to the donor and the charity. Gifting a life insurance policy can greatly reduce the donor’s taxable estate, which can save thousands of dollars in estate taxes for upper-income taxpayers. Gifting a policy may also yield a current income tax deduction of the policy’s fair market value. Of course, this deduction can be quite significant in some cases.
Perhaps, most importantly, the charity will receive the entire face amount of the policy upon the death of the insured. This is usually going to be many times the amount they would receive from any rider and can represent a substantial windfall. The cost to the donor, however, will only be a small fraction of that amount each year and any premiums paid after the date of the gift will be deductible as well.
There is also no limit on the size of the policy which may be donated, since charitable donations have no ceiling for estate tax purposes. This strategy also does not impede the donor’s current investment strategy and can also provide a useful way to dispose of an unwanted policy which was originally purchased to cover a need which no longer exists.
Naming a Charity as Beneficiary. Naming the charity of your choice as the beneficiary of your life insurance policy is the simplest way to provide a charity with the death benefit proceeds from a policy, although it does not offer the income tax advantages which come with gifting a policy. It still reduces your estate, however, by the amount of the death benefit. Donors who are unsure of exactly how they want to apportion their assets after death can list a charity as a revocable beneficiary, if they so choose. This gives them flexibility in future planning ,in case their financial situation changes.
Gifting Policy Dividends. Although gifting policy dividends will not provide the same amount of benefit to a charity as the other strategies, it is possible for policyholders to receive the dividends paid to their life insurance policies in cash and donate them to charity. The dividends donated are deductible in the same manner as premiums paid on a gifted policy and this strategy does not require any additional cash outlay from the donor. Corporations can also effectively implement this strategy as a giving policy to realize tax and community benefits.
Your financial advisor can work with your attorney and tax advisor to help you make the most of these charitable giving strategies.
Summit Brokerage Services is a member of Cetera Financial Group, RCS Capital Corporation’s (NYSE: RCAP) retail investment advice platform.
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