Michael and Katelyn Connor recently saw their annual earnings hit a high note. And then came the sour note: the projected tax impact of their bump in income. Similarly, Mike and Julie Snapp were excited by the long-term benefits of converting an IRA to a Roth – until they realized the short-term cost of that shift: more than a million dollars in additional income taxes.
Fortunately, the Connors and Snapps worked with their wealth advisors to forge strategic approaches to these conundrums, and found they not only could reduce their tax bills but, at the same time, could benefit charities they believe in.
As we enter the fourth quarter, you’re likely hearing from clients who face similar year-end dilemmas. The good news is that you have access to a tool that can help your clients the way the Connors’ and Snapps’ advisors helped them: a donor-advised fund (DAF). And it doesn’t take long to put such strategies into play, which means it’s not too late to make a DAF a part of your clients’ 2023 tax-reduction and charitable-giving plan.
A wealth of opportunities
There’s a reason DAFs are the fastest-growing charitable giving tool in America: Although they seem fairly straightforward they can solve a lot of seemingly complex problems and present a wealth of opportunities.
Here are some ways they can address specific year-end challenges and open doors to immediate and long-term benefits:
High earnings year. If, like the Connors, your client has had a particularly good earnings year, you can help your client offset the tax impact by opening a DAF with a public charity such as Renaissance Charitable Foundation. This allows them to enjoy the benefits of making a tax-deductible gift without having to decide immediatelywhat charitable organization(s) should receive funds. (Learn more about the Connors’ solution below.)
Offset taxable event. Like the Connors’ high earnings, a windfall often creates a moment of joy followed by a moment of sad realization. A DAF can help reduce the blow created by a taxable event.
Roth conversion. For some investors, converting IRAs to Roth IRAs makes great long-term sense, but it can be daunting to consider the immediate tax impact. A DAF like the one the Snapps created can help to reduce the negative effects of the conversion. (Learn more about the Snapps’ DAF strategy below.)
Bunching charitable deductions. Clients who have trouble exceeding the standard deduction amount can “bunch” contributions from years to come into one year by putting them into a DAF. This will allow the client to exceed the standard deduction level for one year by making a large charitable contribution, and then use the DAF to support their charities as they normally do each year. Plus, this approach frees up cash flow in future years because charitable giving is now funded from DAF rather than from their personal cash flow.
Portfolio rebalancing. Periodic portfolio rebalancing often results in taxable gains. Charitable donations can help to offset that tax impact, and a DAF would allow your client to enjoy that tax solution with a one-time charitable contribution that can be granted to charities over time.
Avoid capital gains on appreciated securities. By donating appreciated securities directly to a DAF, a donor can disburse the assets without a taxable capital gain and also create a long-term vehicle for giving.
Streamline tax reporting. Accounting for charitable giving can be a nightmare. Donors need to make sure they get documentation from all the charities they support and they have to be certain it all gets reported correctly. DAFs simplify this process, as the DAF administrator compiles and supplies all documentation needed for tax reporting.
So, how do solutions like these work in real life? Let’s look more closely at the experiences of the Connors and Snapps.
For a recent year, the Connors saw their projected adjusted gross income rise to $200,000. For a couple with a total net worth of $2 million, including qualified retirement accounts and other investments, they found themselves with an anticipated income tax bill of $43,000.
The Connors’ financial team saw a way out. By creating a DAF for their charitable giving and transferring $50,000 in appreciated securities to that DAF, the Connors would benefit in two ways on their taxes: They would avoid the capital gain on the appreciated securities and have a qualified charitable deduction against their adjusted gross income.
Let’s look at the numbers. The $50,000 contribution to the Connors’ DAF provided a $50,000 income tax deduction and current income tax savings of $14,000. Michael and Katelyn also avoided $6,000 in state and federal capital gain taxes on the highly appreciated securities transferred to their DAF, for a total tax savings of $20,000.
Michael and Katelyn see additional advantages to this approach. With the DAF in place, they can use it to engage and educate their children about the importance of charitable giving by including them in the process of granting DAF funds and allowing them to make recommendations about the DAF’s distributions to charities. With this experience, the Connor children will be well-equipped to assume the grant making upon Michael and Katelyn’s passing.
Mike and Julie Snapp are at a different stage in life. They’re both 75 and they’re looking for ways to reduce their ongoing tax burden in retirement. As such, they are thinking about converting their $3 million IRA to a Roth IRA. However, converting the entire IRA would create an additional $1,018,000 income tax hit in addition to a required minimum distribution (RMD) of $122,000.
A strategy with a DAF at its core offers the opportunity to reduce the Snapps’ taxes hit and help to fund the RMD.
The Snapps’ financial advisor suggests a plan that combines the Roth Conversion, RMD and normal charitable giving. (Mike and Julie give about $20,000 each year to their church, college, and a local museum, and they plan to significantly increase those gifts in the future.) Their advisor’s suggestion: Execute a $1 million Roth Conversion and withdraw another $1.5 million from their IRA to cover their RMD and create a $1 million DAF.
By creating a DAF named the Mike and Julie Snapp Charitable Fund, the Snapps reduce their income taxes by $533,000. They will use the remining $485,000 from the withdrawal to pay their tax bill. Their advisor recommends keeping the rest of the money in the existing traditional IRA.
The result? Mike and Julie have a Roth IRA that will provide them with tax-free income in the future, their tax and RMD problems are addressed and their favorite charities will be permanently supported by the Mike and Julie Snapp Charitable Fund.
It’s not too late for 2023
If you’re thinking this all sounds great, but there’s no way to pull it off this year, there’s some good news for you.
It’s not too late to create a DAF and put its benefits to work. Ren helps with a simple, streamlined process and, while your clients can use other public charities to administer their DAFs, Renaissance Charitable Foundation offers a ready option that currently supports more than $2 billion in DAF assets for financial firms and nonprofits across the U.S.
Something else to help your clients understand is that, with a DAF, they can make a decision that delivers 2023 tax benefits without deciding between now and the end of the year exactly what charities they want to support. Contributions to a DAF are immediately tax deductible, even if the funds aren’t granted out to charities until a future date. This not only allows for more thoughtful consideration of gifts, but it also supports long-term giving goals and objectives.
One caveat, though: If your client wants to use a DAF to offset appreciation in non-cash assets such as business interests, real estate, and fine art, it could take a little longer to finalize the process. As such, don’t wait any longer to have a conversation with your client so we can put the process into motion.
If you want to learn more about how you can help clients with year-end giving, check out our advisor’s year-end checklist. If you’d like to learn more about the way you can help donors reach their philanthropic goals, talk to our experts at Ren.