In our never-ending search for paying fewer taxes, consider two definitions from the IRS:
- Tax evasion: The failure to pay or a deliberate underpayment of taxes.
- Tax avoidance: An action taken to lessen tax liability and maximize after-tax income.
The IRS explains that tax avoidance is legal. As taxpayers, there is nothing wrong with avoiding taxes through deductions, credits, and different strategies. Charitable giving is an interesting way for philanthropic taxpayers to minimize their tax liability over the long term.
Many financial professionals suggest bundling giving, donating appreciated assets, and using donor-advised funds. There are many more tax-saving strategies that deal with charitable giving, but these are some of the most commonly used.
What Is Bundling?
Let’s take the first strategy — bundling giving. For example, consider an individual who makes a $20,000 donation to their charity of choice and is able to itemize their deductions for the year because it’s a few thousand more than the standard deduction. They’re excited knowing that they saved more on taxes while donating to charity.
This can be a good strategy, and many choose to do it, but there may be a better way. Unfortunately, they really only deducted a fraction of their donation because it barely put them above the standard deduction.
Alternatively, by bundling giving, you might give a few years’ worth of donations in one year, putting you well beyond just the standard deduction. Your tax savings are much higher because the bundled giving allows you to take full advantage of itemizing.
Donating Appreciated Assets
The second strategy is donating appreciated assets. Imagine you have a taxable brokerage account with mutual funds that have unrealized capital gains.
This means that they are worth more than what you purchased them for. This is a common situation for long-term investors because the market tends to go up over time. To use the funds, investors would have to sell their positions, creating a taxable event. This could leave investors with a large tax bill as they realize taxable gains.
Depending on the investor’s income, they could be paying 0%, 15%, or 20% on those long-term gains, with higher rates for short-term gains. But, by gifting assets that are appreciated, you can do the following instead:
- Fulfill your giving goals.
- Eliminate the capital gains tax embedded in those positions tax-free.
For those reasons, donating appreciated assets can be a great way for investors to give to their favorite charities while optimizing their tax situation.
What Is a Donor-Advised Fund?
The third strategy is using what’s called a donor-advised fund (DAF). Essentially, a DAF is an investment vehicle that holds your donated assets. You control the timing, amount, and recipients of any giving from this fund.
There are some important things to know about DAFs. For starters, your donation becomes tax-deductible when you make a contribution to your DAF. The contribution can then grow and compound until you have years of giving saved up.
Another important aspect of a DAF is that all the assets in the DAF are no longer the investor’s. A contribution is considered a donation for tax purposes, so once it leaves your hands, it is no longer your asset.
Another way investors can use a DAF is by combining all three of the mentioned strategies. Making a large, sizable donation of appreciated stock to a DAF. This strategy eliminates the capital gains and allows you to maximize your itemized deductions because of the large donation.
Large contributions to a DAF could also be used to offset income from some tax-triggering event, such as a Roth conversion or sale of a business. For example, imagine you convert $20,000 from your traditional IRA to your Roth IRA. Doing so would add $20,000 to your income for the year.
If you had $20,000 in cash, you could donate the cash to your DAF. This would help offset the income from the conversion and minimize your taxes substantially. Because these strategies can be quite complex and include a lot of moving parts, it’s important to seek the best financial advisors in Utah to help determine if these strategies are even appropriate for your unique situation.
Tax saving strategies often require delaying gratification. Roth conversions, for example, have you converting some amount of pre-tax money (i.e., traditional IRA’s) to after-tax (Roth). You pay the taxes now but reap the rewards later down the road.
Making Roth contributions to a Roth 401(k) means that you forgo the tax deduction now for tax-free growth and tax-free withdrawal. This can be difficult and often requires tremendous patience and foresight.
Angela Duckworth wrote a fantastic book called “Grit.” In the book, Duckworth wrote,
“Grit is passion and perseverance for long-term goals. One way to think about grit is to consider what grit isn’t. Grit isn’t talent. Grit isn’t luck. Grit isn’t how intensely, for the moment, you want something. Instead, grit is about having what some researchers call an “ultimate concern”–a goal you care about so much that it organizes and gives meaning to almost everything you do. And grit is holding steadfast to that goal.”
Having grit is completely applicable and necessary in achieving your financial goals. And fortunately, grit doesn’t require special talent or luck. Neither does investing for the long-term. Whatever you call it — grit, perseverance, sticking with it — that is what sets you apart from the average investor. That is what will ultimately bring you to accomplishing your financial goals.
Work With a TrueNorth Wealth Advisor
Your first step to financial independence is working with a trusted advisor who can guide you through the intricacies of income tax planning. TrueNorth Wealth has qualified fee-only financial planners in Boise, ID, and beyond. Visit one of our four locations, and we’ll devise the best tax-saving strategies tailored to you and your financial goals!