Three Year-End Strategies That May Help Reduce Your Taxes
For some qualified investors, a Qualified Charitable Distribution (QCD), a Donor Advised Fund (DAF), or a Roth Conversion can make a lot of tax sense.
As we near the end of the year, we spend a lot of time thinking about tax efficiency and how we can help clients identify and implement strategies that can help reduce their taxes. Some of these strategies, like tax-loss harvesting, may be more widely applicable to a broad range of clients. Other more niche strategies are specifically targeted to clients who meet certain criteria. We highlight three of these in this newsletter.
Strategy #1: Qualified Charitable Distribution (QCD)
Consider a QCD if you: 1) are age 70½ or older; 2) have excess pre-tax IRA savings that you may not need for retirement income; 3) are charitably minded. Learn More >
Strategy #2: Donor Advised Fund (DAF)
Consider a DAF if you: 1) wish to avoid taxes on appreciated securities; 2) wish to increase deductions in any one year, especially in relation to the standard deduction; 3) are charitably minded. Learn More >
Strategy #3: Roth IRA Conversion
Consider a Roth Conversion if you: 1) have pre-tax IRA savings; 2) wish to reduce the lifetime taxes of you and your heirs, 3) are in a low tax year, or expect your taxes to increase in the future. Learn More >
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Strategy #1: Qualified Charitable Distribution (QCD)
If you are 70½ or older and have a pre-tax IRA, you can donate up to an annual maximum of $100,000 from the IRA to a qualified charity (or charities). This is called a Qualified Charitable Distribution (QCD), and it can be a win-win way to distribute excess IRA savings tax free while supporting charities you care about.
Because a QCD is issued directly to the charity, the funds are not reportable as income to the IRS and thus are not taxable. The funds do not go on your Form 1040 and this income exclusion can positively impact other tax calculations related to Social Security and Medicare.
QCDs can be made after age 70½ and before Required Minimum Distributions (RMDs) at age 72. These pre-RMD distributions can have the benefit of reducing future RMDs.
After age 72, clients who must start taking RMDs from their IRA but do not need the funds for income may choose to make a QCD so they aren’t taxed on the distribution. A QCD cannot be made to a private foundation, donor advised fund (DAF), charitable gift annuity, or charitable remainder trust (CRT).
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Strategy #2: Donor Advised Fund (DAF)
Another tax strategy option for charitably minded clients is to establish a Donor Advised Fund (DAF), which is technically a tax-qualified public charity that you create and fund up front to receive an immediate tax deduction. You can then define your own donation schedule and spread your giving to qualified charities over multiple years. The funds have the potential to grow tax-free in the DAF until donated, and unlike rules for a foundation, there is no required grant distribution quota or schedule.
Advantages of a DAF include:
You receive an immediate deduction for the full value of your up-front DAF funding*, even if you choose to make the actual charitable donations at later dates.
This can be a strategic alternative to spreading smaller donations over multiple years but having to forgo a deduction benefit because the amount in any single year is too low.
You can fund a DAF using appreciated securities or mutual fund shares and not pay capital gains tax.
In a nutshell, a DAF is a more streamlined and cost-effective alternative to setting up your own private foundation (many private foundations are converting to DAFs for this reason). You can even name it as you wish (Example: The Estes Family Foundation).
* Some deduction limits apply, based on AGI. But any amount that can’t be deducted in the current year can be carried over and deducted for up to five succeeding years.
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Strategy #3: Roth IRA Conversion
It’s typical at retirement for clients to have amassed a sizeable savings in pre-tax retirement accounts. But the tax bill comes due on those pre-tax funds as you start to take distributions, whether elective or required. Doing a Roth IRA Conversion is an increasingly popular strategy with some investors for reducing their tax obligation and potentially that of future heirs.
As an example, some retirees are opting to convert all of part of their pre-tax IRAs to Roth IRAs during the years immediately after retirement when they have more than enough resources to live on and find themselves in a lower tax bracket than in their working days—and possibly a lower bracket than in the future when social security and RMDs increase taxable income.
The “Gap Years” between retirement and taking social security may provide an opportunity to convert pre-tax IRA funds to a Roth IRA, taking advantage of the lower tax bracket.
The Roth conversion process does mean paying taxes now on the pre-tax IRA funds—but at what ideally is a lower tax rate now than in the future (creating a lower lifetime tax liability). Once converted, there are no taxes on future Roth IRA distributions, nor are there required minimum distributions (RMDs). The converted assets can grow tax deferred throughout the remainder of your lifetime, and you can still access the funds tax-free.
But the greatest benefit of doing a Roth IRA conversion may be for the next generation. If you do not need all your IRA savings during your lifetime, converting to a Roth IRA will allow the tax-free transfer of funds to future beneficiaries without the tax burden of the 10-year distribution rule for inherited pre-tax IRAs.
Using special tax software, we can analyze your specific income and tax profile to assess whether a Roth conversion makes sense. If we determine that it does, we can then calculate the optimal amount and timing that won’t bump your adjusted gross income (AGI) to a higher tax bracket or inadvertently increase social security taxes and Medicare premiums. We can also work with your tax accountant to communicate the recommended strategy.
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In addition to not being much fun, taxes can be complicated. We are not tax professionals, but we can help—working in partnership with your tax preparer—to identify possible tax reduction opportunities that may work for you. If we believe a client is a candidate for any of the strategies described in this newsletter, we will be reaching out. If you have questions, you may always contact us as well.
Any opinions in this newsletter are those of Estes Wealth Strategies and John Estes and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information presented herein has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a statement of all available data necessary for making a recommendation, nor does it constitute a recommendation.
While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Unless certain criteria are met,
Donors are urged to consult their attorneys, accountants or tax advisors with respect to questions relating to the deductibility of various types of contributions to a Donor-Advised Fund for federal and state tax purposes.
Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.