Tag Archives: QCD

The Church IRA

“Repay to Caesar what belongs to Caesar and to God what belongs to God.” – Matthew 22:21

What happens with our IRAs and other retirement accounts when we die? Early in our financial journeys, it is incredibly important to plan for our retirement accounts to take care of our loved ones, particularly spouses and younger children. Those concerns should be the primary drivers of the planning for our retirement accounts early on.

But what about later in our lives, when our financial futures are secured and our children are adults?

I believe it is time to be intentional about the destination of our tax deferred retirement accounts. It’s great to provide for adult children. But how much? And couldn’t retirement accounts help better the world? As discussed below, the Church IRA is a way to give wealth to adult children and to the Church.

The Origins of an Idea

In August 2023 the combination of a West Coast hurricane and the Podcast Movement conference resulted in my flying to Denver, Colorado on a Saturday to ensure I could attend the conference. As a result, I attended Sunday Mass far from home at St. Gianna Beretta Molla Church in Denver. At that Mass, the homilist, Deacon Steve Stemper, had an idea that spoke to me: treat the Church as one of your children in your estate plans.

The Church IRA

As frequent readers of the blog know, I’m quite interested in tax-advantaged retirement accounts. The idea to treat the Church as one of your children in your estate strikes me as particularly well suited for traditional IRAs.

Let’s illustrate with an example:

Chuck and Joy are married and both are 85 years old. They have a $3M traditional IRA in Chuck’s name, and they have three adult sons: Abe, Barry, and Charlie, in their late 50s and early 60s.

Obviously, if Chuck dies, Joy needs support. Why not name Joy as the primary beneficiary of the traditional IRA? That leaves a remaining question: who should be the secondary beneficiaries?

Each of Abe, Barry, and Charlie could be a one-third secondary beneficiary. At the second death, they would get about $1M each. What if instead Chuck names each of Abe, Barry, and Charlie one-quarter secondary beneficiaries (about $750K each) and names his Catholic parish or diocese as a one-quarter secondary beneficiary (also about $750K)?

This is the beginning of what I refer to as the Church IRA.

How much different will Abe, Barry, and Charlie’s lived experience be by inheriting a $750K traditional IRA instead of a $1M traditional IRA?

Further, the “hit” to Abe, Barry, and Charlie is likely to be less than a 25% reduction. Why? Because of taxes!

Each of Abe, Barry, and Charlie will have 10 years to drain the inherited IRA. Odds are they will want to take more than 10% per year from the IRA to manage a potential “Year 10 Tax Time Bomb.” Say Abe is single and otherwise has annual income of $150,000.

If Abe takes 12.5% of the account in the first full year after death, he takes $125,000 if he inherits a $1M traditional IRA. Assuming he takes the standard deduction, Abe will be in the 35% marginal tax bracket.

If, instead, Abe inherits a $750K traditional IRA, he only takes $93,750 in the first year. With the other $150K of AGI, Abe will find himself in the 32% marginal tax bracket.

The $31,250 that the Church IRA costs Abe during the year would have been taxed at 32% and 35% federal income tax rates. This illustrates that reducing Abe’s inherited IRA by 25% is not likely to cost him 25% of the after-tax wealth since it is likely he would pay a significantly higher tax rate on those last dollars.

You could say Chuck and Joy “took” money from Abe, Barry, and Charlie by employing the Church IRA. The money they took from Abe, Barry, and Chuck and gave to the Church is the highest taxed money, making the Church IRA tax efficient.

The Church IRA and the Owner’s Needs

One of the advantages of the Church IRA is it need not risk the owners’ own retirement sufficiency. Joy has a legitimate interest in her own financial future. The initial Church IRA structure has the advantage of reducing Chuck and Joy’s ability to fund the remainder of their own lives in no way. The Church gets money only after they have both passed.

Church IRA Implementation

To my mind, the biggest question here is whether to create the Church IRA during our lives or at death. In Chuck and Joy’s case, assuming they want to, at a minimum, employ the Church IRA at death, there are three options:

PATH ONE: Keep everything in a single IRA during their lifetimes. Have the four equal secondary beneficiaries.

PATH TWO: Split the single IRA into four IRAs, each with its own 100% secondary beneficiary (Abe, Barry, Charlie, and the Church IRA)

PATH THREE: Split the single IRA into two IRAs (one worth $2.25M with Abe, Barry, and Charlie as the secondary beneficiaries and a second IRA worth $750K with the Catholic Church as the sole secondary beneficiary).

One of the advantages of the second and third paths is the Church IRA can serve additional purposes. One additional Church IRA purpose is that it be used during Chuck and Joy’s lifetimes to make their routine contributions to the Church (whether that be weekly or monthly). Those contributions can be made through qualified charitable distributions (“QCDs”).

QCDs are a great tax planning tactic during one’s own lifetime for the charitably inclined. They get money out of a traditional IRA tax-free and count against required minimum distributions (“RMDs”).

Regardless of the chosen path, the Church IRA can also be used during Chuck and Joy’s lifetime to help them fund their own living expenses.

We see that the Church IRA can be simply used at death through beneficiary designation forms. Or the Church IRA can also work during one’s own life to either or both (i) provide for routine lifetime Church donations (preferably through QCDs) and (ii) provide for the owner’s own living expenses.

Splitting IRAs

IRA owners can work with their financial institution to split an existing IRA into two or more IRAs. This can be done for any reason. Perhaps it’s simply for mental accounting to facilitate a Church IRA like the one in Paths Two and Three described above.

One does not need to split IRAs to facilitate the Church IRA (see Path One above). But there can be simplicity advantages to having each beneficiary have their own separate and distinct IRA they inherit separate from other siblings and/or the Church.

RMDs from Split IRAs

Here the tax rules are quite flexible. The tax rules treat all of one’s traditional IRAs as a single traditional IRA for RMD purposes. So Chuck and Joy would have tremendous flexibility in terms of which IRA or IRAs to take their overall RMD for the year from. They could take the RMD from the Church IRA or from one or more of the non-Church IRAs, or they can split it among their various IRAs however they want to.

Changing Beneficiaries at the First Death

In Chuck and Joy’s situation, there is an important additional consideration. What if Chuck dies first? Joy would inherit the traditional IRA. She would then need to work with the financial institution to appropriately roll the inherited IRA into an IRA into her own IRA.

From there, she should name primary beneficiaries in accord with her Church IRA intention. She has the three paths described above as possibilities for structuring her Church IRA.

Roth Versus Traditional

Absent incredibly rare circumstances, the Church IRA should be a traditional IRA. Roths are tax-free to individual beneficiaries. Traditional IRAs are taxable to individual beneficiaries. If your adult children are getting some and the Church is getting some, why not leave Roths to the adult children and some or all of the traditional IRAs to the Church?

The adult children pay income tax and the Church does not. Why waste the tax-free attribute of the Roth on a tax-free entity, the Church? The Church does not benefit from Roth treatment while the adult children do.

Perhaps the beneficiary designation forms split the Roth IRA only among the adult children and split the traditional IRA among the adult children and the Church, and leave a greater percentage of the traditional IRA to the Church.

Conclusion

The Church IRA can flexibly leave a share of one’s financial wealth to the Church or other 501(c)(3) charity. It can help us repay to God what is God’s while reducing what is owed to Caesar.

To determine whether the Church IRA is appropriate for us, we need to ask ourselves several questions. How much do my adult children need? Should I leave a significant amount to my Church or other charities? Are there tax-efficient ways to provide for both the Church and my adult children?

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Traditional Versus Roth 2023

The debate continues: what’s preferable, traditional retirement accounts or Roth retirement accounts?

Fortunately, there are plenty of shades of gray in this debate. There’s no “right” answer, but I do believe that there are good insights that can help individuals make the right planning decisions for themselves.

Traditional and Roth Retirement Basics

Before we dive into the traditional versus Roth debate, we should quickly survey the basics of these types of retirement accounts.

Traditional

Traditional retirement accounts feature a tax deduction on the way in (i.e., for contributions) and ordinary income tax on the way out (i.e., for withdrawals). At work these are known as traditional 401(k)s, 403(b), 457s, and occasionally have other names. At home these are known as traditional IRAs.

Additional twist: many working Americans do not qualify to deduct a traditional IRA contribution due to relatively low income limits on claiming a deduction.

Part of the appeal of traditional retirement accounts includes: (i) the notion that many will have lower taxable income (and thus lower income tax) in retirement than they did during their working years and (ii) the tax saved by contributing to traditional accounts can be invested, potentially creating more wealth for retirement.

Roth

Roth retirement accounts feature no tax deduction on the way in (i.e., for contributions) and tax free treatment on the way out (i.e., for withdrawals). At work these are known as Roth 401(k)s, 403(b), 457s, and (after SECURE 2.0 implementation) will occasionally have other names. At home these are known as Roth IRAs.

Additional twist: some working Americans do not qualify to make an annual Roth IRA contribution based on income limits, but many can get around this rule by implementing a Backdoor Roth IRA.

Part of the appeal of contributions to Roth retirement accounts is the notion that it is better for our younger, healthier selves to pay the tax associated with retirement savings when cash flow is good and the investor knows they can bear the cost.

The basics out of the way, we can get into 2023 insights on the debate between the two types of retirement accounts.

The Risk of Traditional Retirement Accounts is Vastly Overstated

We hear it time and again: be worried about all the tax lurking inside traditional retirement accounts such as 401(k)s and IRAs!

Here’s the thing: rarely do commentators offer any sort of mathematical analysis backing up that contention. I ran the math, and I repeatedly find that many retirees with traditional retirement accounts are likely to pay Uncle Sam a very manageable amount of income taxes in retirement.

You be the judge and jury. I believe a fair assessment of my posts and videos and the numbers behind them shows that most Americans do not face a high risk of crippling federal income taxes in retirement, even if the vast majority of their portfolio is in traditional 401(k)s and IRAs.

While I cannot give readers of this blog individualized advice, I can say that if one considers themselves to be an “Average Joe” it is difficult to see how having significant amounts in traditional retirement accounts is a problem.

The Needle Keeps Moving Towards Traditional

Picture it: United States, September 2017, six short years ago. You’re bright-eyed, bushy-tailed, and fear only one thing: incredibly high taxes on your traditional 401(k) and IRA in retirement.

Then a few things happened.

December 2017: TCJA increased the standard deduction and lowered the 15% bracket to 12%
December 2019: The SECURE Act (SECURE 1.0) delayed RMDs from age 70 ½ to 72
March 2020: CARES Act cancels 2020 RMDs and allows taken RMDs to be rolled back in
November 2020: IRS and Treasury issue a new Uniform Life Table, decreasing the amount of annual RMDs beginning in 2022
December 2022: SECURE 2.0 delays RMDs from age 72 to 73, and all the way to age 75 for those born in 1960 and later

Tax cut after tax cut for traditional retirement accounts and retirees! In the traditional versus Roth debate, DC keeps putting a thumb on the scale for traditional.

Watch me assess recent tax law change history as it applies to retirees.

Taxable Roth Conversions Going Away?

One reason I like traditional 401(k) contributions is that they do not close the door on Roths. Rather, traditional retirement account contributions at work are a springboard for years of Roth conversions in retirement for many in the FI community!

The idea is to take deductions at high marginal tax rates at work into a 401(k) and build up wealth for an early retirement. Then, in retirement, one’s tax rate is artificially low as they no longer have W-2 income to report. This opens up room for potentially very efficient Roth conversions (affirmatively moving money in traditional accounts to Roth accounts) taxed at the 10% or 12% federal income tax rate.

That’s a great plan, in theory. But couldn’t Congress take it away? Sure, they could, but I seriously doubt they will in an effective way. First, let’s look at recent history. In 2021 the Democratic Congress proposed, but did not pass, a provision to eliminate (starting a decade in the future) taxable Roth conversions for those north of $400K of annual income. Such a rule would have had no effect on most retirees, who will never have anything approaching $400K of income in retirement.

Second, why would Congress eliminate most taxable Roth conversions? They “budget” tax bills in a 10 year window. Taxable Roth conversions create tax revenue inside that budget window, making it that much less likely a Congress would eliminate most of them.

While there is not zero risk taxable Roth conversions will go away, I believe that the risk is negligible. The greater one believes Roth conversion repeal risk is, the more attractive Roth contributions during one’s working years look.

Special Years Favor Roths

I’ve written before about how workers in the early years of their careers may want to consider Roth 401(k) contributions prior to their income significantly increasing. Those in transition years, such as those starting a job after graduating college and those about to take a mini retirement may want to prioritize Roth 401(k) contributions over traditional 401(k) contributions.

Optimize for Known Trade-Offs

People want to know: what’s the optimal income for switching from traditional to Roth? What’s the optimal percentage to have each of traditional, Roth, and taxable accounts?

Here’s the thing: there are simply too many unknown future variables to come up with any precision in this regard. That said, I don’t believe we have to.

Why? Because in retirement planning, we can optimize for known trade-offs. Let me explain. At work, Americans under age 50 can contribute up to $22,500 (2023 number) to a 401(k). At most employers, that can be any combination of traditional or Roth contributions. Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional deductible 401(k). That’s a known trade-off.

What about at home? For most working Americans covered by a 401(k), a dollar contributed to a Roth IRA is not a dollar that could have been contributed to a deductible traditional IRA. So a Roth IRA contribution is not subject to the trade-off downside that a Roth 401(k) contribution is.

Why not optimize for known trade-offs? Contribute to a traditional 401(k) at work and a Roth IRA (or Backdoor Roth IRA) at home. This approach optimizes for the known trade-offs and sets one up with both traditional and Roth assets heading into retirement.

Further, Roth IRA contributions and Backdoor Roth IRAs can serve as emergency funds, while traditional IRAs, traditional 401(k)s, and Roth 401(k)s do not serve well as emergency funds. Roth IRA contributions do not suffer from an adverse trade-off when it comes to emergency withdrawals, unlike Roth 401(k) contributions.

Roth Contributions End the Planning

Traditional retirement account contributions set up great optionality. A retiree may have years or decades of opportunity to strategically convert traditional accounts to Roth accounts. Or, a retiree might say, “thanks, but no thanks, on those Roth conversions, I’ll simply wait to withdraw for RMDs or living expenses later in retirement at a low tax rate.” Traditional retirement account contributions open the doors to several planning options.

Roth contributions end the planning. That’s it, the money is inside a Roth account. Considering the potential to have low tax years after the end of one’s working years, is that always a good thing?

Rothification Risks

Having all one’s retirement eggs in the Roth basket can create significant problems. This is an issue I do not believe receives sufficient attention. Previously I posited an example where an early retiree had almost all his wealth in Roth accounts (what I refer to as the Rothification Trap).

Risks of having all of one’s eggs inside the Roth basket going into retirement include:

Missing out on standard deductions
Inability to qualify for ACA premium tax credits
Missing out on benefits of qualified charitable distributions (QCDs)
Missing out on tax efficient Roth conversions in retirement

Sufficiency

Much of the traditional versus Roth debate misses the forest for the trees. Rarely do commentators state that long before one worries about taxation in retirement they have to worry about sufficiency in retirement!

Recent reports indicate that many if not most Americans struggle to afford a comfortable retirement. A quick review of average retirement account balances indicates that many Americans are not set up for what I’d call a comfortable retirement. Further, according to a recent report, the median American adult has a wealth around $108,000. That means the median adult has a significant sufficiency concern when it comes to retirement planning.

Most Americans will be lucky to have a tax problem in retirement! Most Americans need to build up retirement savings. The quickest, easiest way to do that is by making deductible traditional 401(k) contributions. That deduction makes the upfront sacrifice involved in retirement saving easier to stomach. Further, if one is not likely to have substantial retirement savings, they are not likely to be in a high marginal tax bracket in retirement.

If all the above is true, what is the problem with having taxable retirement accounts? The tax savings in retirement from having Roth accounts is not likely to be very high for many Americans.

Conclusion

Both traditional retirement accounts and Roth retirement accounts have significant benefits. When viewed over the spectrum of most Americans’ lifetimes, I believe that workplace retirement plan contributions should be biased toward traditional retirement accounts. For many Americans, either or both of the following will be true. First, there will be low tax years in retirement during which retirees can take advantage of low tax Roth conversions. Second, many Americans will be in a low tax bracket when taking retirement account withdrawals for living expenses and/or RMDs.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Time to Stop 401(k) Contributions?

Ed Slott believes most Americans should not contribute to traditional 401(k)s. His recent essay on the subject is a great opportunity for the FI community to reassess its love for the traditional 401(k).

My conclusion is that for many in the FI community, traditional deductible 401(k) contributions are still the most logical path when it comes to workplace retirement saving. Below I explain my thinking.

It is important to note it is impossible to make a blanket statement as applied to the entire FI community.

Why the Traditional 401(k) Is Good for the FI Community

Many in the FI community have the very reasonable hope that in retirement they will have years, possibly decades, where their effective tax rate will be lower than their marginal tax rate in their working years.

The above is true of many Americans, but it is particularly true if one retires early by conventional standards. The idea is deduct, deduct, deduct into the 401(k) during one’s working years (particularly the high earning years) and then retire early by conventional standards. Prior to collecting Social Security and/or required minimum distributions (“RMDs”), most retirees look artificially poor on their tax return. This opens up the door to affirmatively convert money from traditional retirement accounts to Roth accounts and pay tax at the lowest federal income tax brackets (currently 10% and 12%). For those who deducted contributions into the 401(k) at a 24% or greater marginal federal tax rate, this is great tax rate arbitrage planning.

Minor litigation risks aside, this strategy just got even easier for those born in 1960 and later, who don’t have to take RMDs under SECURE 2.0 until age 75. With the new delayed RMD beginning date, even those retiring as late as age 65 will have a full decade prior to being required to take RMDs to do tax-efficient Roth conversions at low marginal tax rates. For some in the FI community, this opportunity window might not be a decade long but rather a quarter-century long (if they retire at age 50).

How Bad is the Retiree Tax Problem?

As wonderful as FI tax rate arbitrate planning might be, Ed Slott’s concern that retiree taxes will increase is not entirely unwarranted. It is obvious that the government is not fiscally responsible, and it is obvious that tax increases could be coming in the future.

Let’s assess the situation by looking at just how bad the problem of taxes is in retirement.

We begin with a baseline case. David and Hannah are in their 70s. They never did Roth conversions in early retirement and have the bulk of their financial assets in traditional IRAs and traditional 401(k)s. During most of their working years, David and Hannah maxed out 401(k)s and got deductions in the 24% bracket or greater. For 2023, they have taxable RMDs of $160,000, Social Security of $40,000, $4,000 of qualified dividends and $1,000 of interest income. How bad is their federal income tax situation?

Federal Income Tax Return
RMDs	$ 160,000
Social Security	$ 40,000
15% Social Security Exclusion	$ (6,000)
Interest	$ 1,000
Qualified Dividends	$ 4,000
Adjusted Gross Income (“AGI”)	$ 199,000
Standard Deduction	$ (27,700)
Additional SD Age 65+	$ (3,000)
Federal Taxable Income	$ 168,300
Federal Income Tax (Estimated)	$ 27,361
Effective Tax Rate on AGI	13.75%
Marginal Federal Income Tax Rate	22%

Under today’s rules, David and Hannah, who did no tax planning other than “deduct, deduct, deduct” are doing great. Their federal effective tax rate, even with $200K of RMDs and Social Security, is just 13.75%. They incur such a low effective tax rate because their RMDs go against the 10% tax bracket, the 12% bracket, and the 22% bracket.

While I do think David and Hannah would be in a better position had they done some tax efficient Roth conversion planning earlier in retirement, their unbridled enthusiasm for traditional retirement accounts served them well.

Note: David and Hannah are borderline IRMAA candidates: a $199K 2023 AGI might cost them approximately $2,000 in IRMAA surcharges in 2025 (but it is possible that inflation adjustments for 2025 will prevent that from happening). This is another reason to consider pre-RMD Roth conversions at lower marginal tax rates.

Update 8/19/2023: But what about the widow’s tax trap? If David or Hannah die, won’t the survivor get crushed by tax increases? Check out this estimate. Assuming the survivor loses the lower-earning spouse’s Social Security benefits of at least $10,000, the survivor’s marginal federal income tax rate would climb from 22% all the way up to . . . 24%!

But what about future tax increases? Okay, let’s add four tax increases to the picture and see just how bad it looks:

Eliminate the TCJA increase to the standard deduction (the law reverts to pre-2018 lower standard deduction and personal exemptions). This would reduce David and Hannah’s deductions by roughly $2,740, costing them approximately $602.80 in additional federal income tax (at today’s 22% marginal tax rate).
Eliminate the TCJA decrease in the 15% tax bracket to 12%. This would cost David and Hannah $2,023.50 in additional federal income tax. I’m highly skeptical that either of these two tax increases will actually occur, but as written in today’s laws they are scheduled to happen in 2026.
Increase the 15% long term capital gains and qualified dividend income rate to 25%. While I believe that the real risk is an increase in the 20% long term capital gains and qualified dividend income rate, let’s stress test things and consider a large increase in the 15% rate. In David and Hannah’s case, this costs them $400 in additional federal income tax.
Increase the 22% tax rate to 33%. Ed Slott is worried about large tax rate increases, so let’s consider one that I believe is politically infeasible, a 50% increase in the 22% tax bracket. This type of tax rate increase would hit millions of voters in a major way. But it’s helpful to consider what could be a worst case scenario. In this case, this tax rate increase costs David and Hannah an additional $8,233.50 in federal income tax.
There’s one more tax hike to consider: the combination of tax increases numbers 1 and 4. If both occurred together, combined they would cost David and Hannah an additional $301.40 in federal income tax.

Here’s what David and Hannah’s federal tax picture looks like if all of the above tax increases occur:

Federal Income Tax Return
RMDs	$ 160,000
Social Security	$ 40,000
15% Social Security Exclusion	$ (6,000)
Interest	$ 1,000
Qualified Dividends	$ 4,000
Adjusted Gross Income (“AGI”)	$ 199,000
Standard Deduction	$ (15,240)
Additional SD Age 65+	$ (3,000)
Personal Exemptions	$ (9,720)
Federal Taxable Income	$ 171,040
Federal Income Tax (Estimated)	$ 38,922
Effective Tax Rate on AGI	19.56%
Marginal Federal Income Tax Rate	33%

Significant tax increases hurt David and Hannah, but how much? By my math, very significant tax increases, including a 50% increase in the 22% bracket, cost them about 6% of their income. Not nothing, but wow, they’re still doing very well.

Yes, on the margin, the last dollars David and Hannah contributed to the traditional 401(k) were not ideal since they faced a 33% marginal federal tax rate in retirement. But let’s remember (i) their overall effective rate is still more than 4 percentage points lower than their working years’ marginal rate (at which they deducted their 401(k) contributions), (ii) they have income significantly above what most Americans will have in their 70s, and (iii) in my scenario they face four separate tax hikes and still pay a federal effective tax rate less than 20 percent.

Future Retirees’ Tax Risk

Do future tax hikes pose no threat to future retirees? Absolutely not! But my stress test shows that many Americans with substantial RMDs will not get walloped even if Congress enacts unpopular tax increases. Considering many in the FI community will have modest RMDs due to pre-RMD Roth conversions, the threat of future tax hikes is even less perilous for the FI community.

Further, many Americans, particularly those in the FI community, have a great tool that can mitigate this risk: Roth conversions during retirement! With RMDs now delayed to age 75 for those born in 1960 and later, many Americans will have years if not decades where money can be moved in a tax-efficient manner from old traditional accounts to Roth accounts.

Further, many Americans can claim deductions at work and then at home contribute to a regular Roth IRA or a Backdoor Roth IRA. This too mitigates the risk of having all of one’s retirement eggs in the traditional basket.

Last, do we really believe that Congress is just itching to raise taxes on future retirees? Sure, it’s possible. But to my mind taxes are more likely to be raised on (i) those in higher ordinary income tax brackets and/or (ii) long term capital gains and/or qualified dividends (particularly the current 20% bracket). If anything, the most Congress is likely to do to retirees is slightly increase their taxes so as to mitigate the political risk involved in raising taxes on retirees who tend to vote.

The Risks of Not Having Money in Traditional Retirement Accounts

Risk isn’t a one-way street. There are some risks to not having money in traditional retirement accounts. I identify three below.

Qualification for Premium Tax Credits

Picture it: Joe, age 55, retires with the following assets: (i) a paid off car, (ii) a paid off house, (iii) a $40,000 emergency fund in an on-line savings account, and (iv), $2 million in Roth 401(k)s and Roth IRAs. He heard that Roth is the best, so he only ever contributed to Roth IRAs and Roth 401(k)s, including having all employer contributions directed to a Roth 401(k). Having fallen into the Rothification Trap, in retirement Joe must work in order to generate sufficient taxable income to qualify for any ACA Premium Tax Credit.

For at least some early retirees, the ability to create modified adjusted gross income by doing Roth conversions will be the way they guarantee qualifying for significant Premium Tax Credits to offset ACA medical insurance premiums.

Charitable Contributions

Many Americans are at least somewhat charitably inclined. Starting at age 70 ½, Americans can transfer money directly from a traditional IRA to a charity, exclude the distribution from taxable income, and still claim the standard deduction. Essentially, if you’re charitably inclined, at a minimum you would want to go into age 70 ½ with enough in your traditional IRAs (likely through contributions to traditional 401(k)s that are later transferred to an IRA) to fund your charitable contributions from 70 ½ until death.

Why ever pay tax on that money (i.e., by making contributions to a Roth 401(k) that are later withdrawn to be donated) if the money is ultimately going to charity anyway?

Unused Standard Deductions

Currently, the government tells married couples, hey, you get to make $27,700 a year income tax free! Why not take advantage of that exclusion every year, especially prior to collecting Social Security (which, in many cases will eat up most, if not all, of the standard deduction).

Why be retired at age 55 with only Roth accounts? By having at least some money in traditional retirement accounts going into retirement, you ensure you can turn traditional money into Roth money tax-free simply by converting (at any time) or even distributing (usually after age 59 1/2) the traditional retirement account against the standard deduction.

Deduct at Work, Roth at Home

I think for many it makes sense to max out traditional 401(k)s at work and contribute to Roth IRAs or Backdoor Roth IRAs at home. Why? As discussed above, traditional 401(k)s can set up tax rate arbitrage in retirement, help early retirees qualify for Premium Tax Credits, and make charitable giving after age 70 ½ very tax efficient. At home, many working Americans do not qualify to deduct IRA contributions, so why not contribute to a Roth IRA or Backdoor Roth IRA, since (i) you aren’t giving up a tax deduction in order to do so and (ii) you establish assets growing tax free for the future.

In this post I discuss why deduct at work, Roth at home can often make sense and I provide examples where Roth 401(k) contributions are likely to be better than traditional 401(k) contributions.

Conclusion

I believe that for many in the FI community, a retirement savings plan that combines (i) traditional deductible 401(k) contributions during one’s working years and (ii) Roth conversions prior to collecting RMDs is likely to be a better path than simply making all workplace retirement contributions Roth contributions.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

Health Savings Accounts and Las Vegas

Want to make a bad financial decision? I’ve got an account that can help you do that tax and penalty free!

Of course, I do not recommend making bad financial decisions. However, at times it is useful to look at extremes to help us better understand and analyze financial planning alternatives.

Health Savings Accounts

If you’ve spent any time on my blog or YouTube channel, you’re probably aware that I’m fond of HSAs. Contributions are tax deductible (or excludable if made through payroll withholding). Amounts inside the HSA grow tax free. Withdrawals for qualified medical expenses, or reimbursements of qualified medical expenses, are tax and penalty free.

As long as the HSA owner is alive, he or she can reimburse themselves from the HSA for qualified medical expenses incurred after they first owned an HSA. Generally speaking, there’s no time limit on HSA reimbursements, other than the owner must be alive to receive the tax and penalty free reimbursement. See “Distributions from an HSA” on page 9 of IRS Publication 969 and Notice 2004-50 Q&A 39.

HSAs are great because they combine the best feature of a traditional retirement account (deduction or exclusion on the way in) with the best feature of a Roth retirement account (tax free treatment on the way out). Further, the lack of a time limit on reimbursements from an HSA provides the owner with tremendous flexibility in terms of deciding when to take tax and penalty free distributions.

Health Savings Accounts PUQME

Previously Unreimbursed Qualified Medical Expenses (PUQME, pronounced “Puck Me”). HSA owners can reimburse themselves tax and penalty free from their HSA up to their amount of their PUQME. PUQME includes qualified medical expenses of the owner, their spouse, and their dependents incurred after the HSA was first established. Qualified medical expenses deducted as an itemized deduction on a tax return (quite rare) do not qualify to be reimbursed from an HSA and thus are not PUQME. PUQME is a technical term I made up. 😉

Restricted Accounts

When we think about taxable brokerage accounts, traditional retirement accounts, Roth retirement accounts, HSAs, and other available options, we should consider the restrictions in place on the use of the funds. The more restrictions in place, the worse the account.

Time Restrictions

Taxable accounts, traditional retirement accounts, and Roth retirement accounts face various time restrictions on withdrawals. For example, taxable accounts qualify for favored long-term capital gains rates if held for a year. Of course, that restriction is academic if there’s a loss or no gain in the account.

Traditional retirement accounts suffer the most stringent time restrictions. Withdrawals occurring prior to the owner turning age 59 ½ are usually subject to the 10 percent early withdrawal penalty. Roth IRAs are not all that time restricted, as amounts withdrawn prior to age 59 ½ are deemed to first be nontaxable withdrawals of prior contributions. Roth 401(k)s can be somewhat time restricted, as amounts withdrawn prior to age 59 ½ are partially deemed to be withdrawals of taxable earnings (usually subject to the 10 percent early withdrawal penalty).

HSAs are somewhat time restricted, though like Roth IRAs, they are not severely so. Once one has PUQME after having opened an HSA, he or she can withdraw money (up to their PUQME amount) from the HSA tax and penalty free.

Use Restrictions

Taxable accounts, traditional retirement accounts, and Roth retirement accounts are great in that they have absolutely no use restrictions. The government does not care what you spend the money on. The tax result is, at least generally speaking, unaffected by use.

There are some exceptions, such as the exceptions to the 10 percent early withdrawal penalty such that early withdrawals from retirement accounts can qualify to avoid the 10 percent penalty. Further, one might say that because of qualified charitable distributions, using traditional IRAs for charitable purposes is use-favored. The above exceptions noted, as a general rule, use does not significantly change the taxation of withdrawals from taxable accounts, traditional retirement accounts, and Roth retirement accounts.

HSA Use Restrictions

HSA distributions that are not used for qualified medical expenses are subject to both income tax and a 20% penalty if the owner is under age 65.

However, recall that there is no time limit on the ability to reimburse oneself tax and penalty free for previously incurred qualified medical expenses. As a practical matter, the lack of time limit results in relatively modest use restrictions on an HSA. Below I’ll illustrate that with an extreme example.

HSAs and Las Vegas

Perhaps you’re yearning for the hot sand, broken dreams, and $5 lobster of Las Vegas. Could an HSA help? Let’s explore that possibility.

Peter, age 70, wants a weekend getaway in Las Vegas. Between a hotel suite, comedy club tickets, airfare, steak dinners, some Texas Hold’em poker, and the breakfast buffet, he estimates it will cost him $10,000.

Peter was covered by a high deductible health plan from age 55 through age 65. He maxed out his HSA annually during that time, and he has never taken a distribution from his HSA. The HSA is now worth $50,000, and between age 55 and today Peter has $30,000 of PUQME.

Could Peter use his HSA to pay for the weekend? Absolutely!

Wait a minute, Sean. Vegas isn’t a qualified medical expense! Sure, it isn’t. But Peter has $30,000 of previously unreimbursed qualified medical expenses. He can take out $10,000 from his HSA tax and penalty free and use it to buy poker chips in Las Vegas. Once an HSA owner has previously unreimbursed qualified medical expenses, they generally do not have an HSA use restriction up to the level of that PUQME.

As a practical matter, even the healthiest Americans are eventually going to have qualified medical expenses. As a result, most HSA owners will have runway, particularly in retirement, to reimburse themselves for previously incurred qualified medical expenses. That reimbursement money is in no way use restricted–it can go for a weekend trip to Vegas if the HSA owner desires.

HSA Planning Risk

But Sean, there’s no way Congress won’t close the loophole! Surely, at some point in the future, Congress will time-limit tax and penalty free reimbursements from HSAs.

I don’t think so, for three reasons.

First, the HSA loophole is not that great. Consider the relatively modest HSA contribution limits. Sure, the government loses tax revenue due to HSAs, but it isn’t that much, particularly compared to vehicles such as Roth IRAs. Further, HSAs are, at most, a loophole during the owner’s lifetime and the lifetime of their surviving spouse. That’s it!

Left to a non-spouse, non-charity beneficiary, the entire HSA is immediately taxable income (typically at the beneficiary’s highest tax rate) in the year of the owner’s death. Death not only ends the loophole, it gives the government a significant revenue raiser by taxing the entire amount at ordinary rates on top of the inheriting beneficiary’s other taxable income.

Second, I suspect Congress wants taxpayers to bailout HSA money tax and penalty free prior to death. The immediate full taxation of HSA balances in the year of death is going to come as a nasty surprise to many beneficiaries.

Imagine significant taxes and perhaps dealing with the paperwork and hassle of reversing what becomes an excess contribution to a Roth IRA because of a surprise income hit due to the death of a loved one. Here’s what that could look like.

Mark and Laura are married and both turn age 47 in 2023. They anticipate about $200,000 of MAGI in 2023, in line with their 2022 income. Expecting their 2023 income to fall well within the Roth IRA modified adjusted gross income limits, each contributes $6,500 to a Roth IRA for 2023 on January 2, 2023. In September, Laura’s father passes away and leaves her an HSA worth $50,000. The HSA inheritance increases their 2023 MAGI to $250,000. The federal income tax hit on inheriting the HSA will be over $10,000.

As a result of their increased income, Mark and Laura are now ineligible to have made the 2023 Roth IRA contributions. The most likely remedial path involves Mark and Laura working with the financial institution to take a corrective distribution of the contributions and the earnings attributable to the contributions. The earnings will be included in Mark and Laura’s MAGI for 2023 as one last insult to inheriting a fully taxable HSA.

This is a lurking issue. If Congress puts 2 and 2 together, they will hope that HSA balances are small at death so as to avoid their constituents suffering a large, unexpected tax bill related to a loved one’s death. Time-limiting tax and penalty free HSA reimbursements would keep more money inside HSAs during an owner’s lifetime (and thus, at their death). At death, this would set up more beneficiaries to have nasty surprises when inheriting an HSA, a fate Congress most likely wants to avoid.

Third, time-limiting HSA reimbursements will go counter to the reason HSAs exist in the first place: to encourage the use of high deductible health plans. Time-limiting HSA reimbursements could trap amounts inside HSAs because taxpayers would lose amounts they could withdraw from the HSA without incurring tax (and a 20 percent penalty if under age 65). If taxpayers believe HSA money could become trapped, fewer will opt for a high deductible health plan. This will lead to increased medical costs as more and more Americans have lower deductibles and become sensitive to medical pricing.

Surviving Spouse’s HSA PUQME

I prepared a short 1-page technical write up providing my views on how previously unreimbursed qualified medical expenses are computed when a spouse inherits a health savings account.

HSA Resource

Kelley C. Long recently authored an excellent article on HSAs in the Journal of Accountancy.

Conclusion

Here’s hoping that you don’t take away the conclusion that HSA owners should spend their HSA money in Las Vegas!

Rather, my primary conclusion is that investments and tax baskets should be assessed considering their time and use restrictions. The fewer the time and use restrictions, the better. Of course, time and use restrictions are not the only factors to consider, but they are significant factors.

Secondary conclusions include (i) the HSA tends to be very flexible and (ii) the tax breaks available to HSA owners are not likely to be repealed or limited by Congress anytime soon.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

QCDs and the FI Community

Qualified charitable distributions (“QCDs”) are an exciting tax planning opportunity, particularly for the FI community. Below I describe what a qualified charitable distribution is and how members of the FI community should think about them when tax planning.

Of course, this post is educational in nature. Nothing in this blog post is tax advice for any particular taxpayer. Please consult your own tax advisor regarding your unique circumstances.

Qualified Charitable Distributions

QCDs are transfers from a traditional IRA directly to a charity. Up to $100K annually, they are (a) not included in the taxpayer’s taxable income, (b) not deductible as charitable contributions, and (c) qualify as “required minimum distributions” (“RMDs”) (to the lesser of the taxpayer’s required minimum distribution or the actual distribution to the charity). Here is an example:

Example 1: Jack and Jill are 75 years old and file their tax return married filing joint. Jack has a RMD from his traditional IRA of $40,000 in 2021. Jack directs his traditional IRA institution to transfer $40,000 during 2021 to a section 501(c)(3) charity. Jack and Jill recognize no taxable income on the transfer, and Jack does not have to take his 2021 RMD (the $40K QCD having covered it). Further, Jack and Jill receive no charitable contribution deduction for the transfer.

Considering that Jack & Jill (both age 75) enjoy a standard deduction of $27,800 in 2021, they get both the standard deduction and a $40K deduction for the charitable contribution from the traditional IRA (since they do not have to include the $40K in their taxable income). This is the best of both worlds. Further, excluding the $40K from “adjusted gross income” (“AGI”) is actually better than taking the $40K as an itemized deduction, since many tests for tax benefits are keyed off of AGI instead of taxable income.

Important QCD Considerations

Take QCDs Early

Generally speaking, it is best that QCDs come out of the traditional IRA early in the year. Why? Because under the tax rules, RMDs come out of a traditional IRA first. So it is usually optimal to take the QCD early in the year so it can fulfill all or part of the required minimum distribution for the year. Then you can do Roth conversion planning (if desired), so long as the full RMD has already been withdrawn (either or both through a QCD and a regular distribution) from the traditional IRA first.

No Trinkets

I don’t care how much you love your PBS tote bag: do not accept any gift or token of appreciation from the charity. The receipt of anything (other than satisfaction) from the charity blows the QCD treatment. So be sure not to accept anything from the charity in exchange for your QCD.

QCDs Available Only from Traditional IRAs

In order to take advantage of QCD treatment, the account must be a traditional IRA. 401(k)s and other workplace plans do not qualify for QCDs. Further, SIMPLE IRAs and SEP IRAs do not qualify for QCD treatment.

As a practical matter, this is not much of an issue. If you want to do a QCD out of a 401(k) or other tax advantaged account, generally all you need to do is rollover the account to a traditional IRA.

QCD Age Requirement

In order to take advantage of the QCD opportunity, the traditional IRA owner must be aged 70 ½ or older.

Inherited IRAs

QCDs are available to the beneficiary of an inherited IRA so long as the beneficiary is age 70 ½ or older.

QCDs For Those Age 70 ½ and Older

If you are aged 70 ½ or older and charitably inclined, the QCD often is the go-to technique for charitable giving. In most cases, it makes sense to make your charitable contributions directly from your traditional IRA, up to $100,000 per year. QCDs help shield RMDs from taxation and help keep AGI low.

QCDs and the Pro-Rata Rule

If you have made previous non-deductible contributions to your traditional IRA, distributions are generally subject to the pro-rata rule (i.e., the old contributions are recovered ratably as distributions come out of the traditional IRA).

However, QCDs are not subject to the pro-rata rule! This has a positive effect on future taxable distributions from the traditional IRA. Here is an example of how this works:

Example 2: Mike is age 75. On January 1, 2021, he had a traditional IRA worth $500,000 to which he previously made $50,000 of nondeductible contributions. If Mike makes a $10,000 QCD to his favorite charity, his traditional IRA goes down in value to $490,000. However, his QCD does not take out any of his $50,000 of basis from nondeductible contributions. This has the nice effect of reducing the tax on future taxable distributions to Mike from the traditional IRA, since the QCD reduces denominator (by $10K) for determining how much basis is recovered, while the numerator ($50K) is unaffected.

QCDs for Those Under Age 70 ½

Those in the FI community considering early retirement need to strongly consider Roth conversions. The general idea is that if you can retire early with sufficient wealth to support your lifestyle, you can have several years before age 70 during which your taxable income is artificially low. During those years, you can convert old traditional retirement accounts Roth accounts while you are taxed at very low federal income tax brackets.

For the charitably inclined, the planning should account for the QCD opportunity. There is no reason to convert almost every dime to Roth accounts if you plan on giving significant sums to charity during your retirement. Why pay any federal or state income tax on amounts that you ultimately will give to charity?

If you are under the age of 70 ½ and are charitably inclined, QCDs should be part of your long term financial independence gameplan. You should leave enough in your traditional retirement accounts to support your charitable giving at age 70 ½ and beyond (up to $100K annually). These amounts can come out as tax-free QCDs at that point, so why pay any tax on these amounts in your 50s or 60s? Generally speaking, a Roth conversion strategy should account for QCDs for the charitably inclined.

Conclusion

For the charitably inclined, QCDs can be a great way to manage taxable income and qualify for tax benefits in retirement. QCDs also reduce the pressure on Roth conversion planning prior to age 72, since it provides a way to keep money in traditional accounts without having to pay tax on that money.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

The SECURE Act’s Impact on the FI Community

In late December 2019 the President and Congress enacted the SECURE Act. The SECURE Act makes some significant revisions to the laws governing IRAs, 401(k)s, and other retirement accounts. This post discusses the impacts of these changes on those pursuing financial independence.

The Big Picture

The SECURE Act is a big win for the FI community, in my opinion.

The FI community significantly benefits from IRAs, 401(k)s, and other tax-advantaged retirement accounts. However, the federal government is facing increasing debts and annual deficits. That puts tax-advantaged accounts in the crosshairs. What Congress gives in tax benefits Congress can take away.

So what does the SECURE Act do? First, it actually gives us a couple more tax advantages during our lifetimes (see “Opportunities” below). Second, it significantly reduces the tax advantages of inherited retirement accounts for our heirs.

For those either with large retirement account balances or planning to have large retirement account balances, any change in tax laws is a potential problem. We should be glad that this round of tax law changes has occurred without our own retirement accounts being negatively impacted. Congress has passed the bill to our heirs, which, right or wrong, is a victory for us.

When you see people in the financial press squawking about how awful the SECURE Act is, remember, it could be a whole lot worse–your retirement account could have been more heavily taxed during your lifetime!

For those pursuing FI, the ability to use tax-advantaged retirement accounts remains the same, and in a couple small ways, has been enhanced. The next generation still has all those retirement account opportunities, even if they won’t be able to benefit from inheriting retirement accounts as much as they do under current law.

Opportunities

Traditional IRA Contributions for those 70 ½ and Older

Starting in 2020, those aged 70 ½ and older will be able to contribute to a traditional IRA. This will open up Backdoor Roth IRA planning for those 70 ½ and older and still working. For those still working (or doing side hustles) at age 70 ½ or older, this is a nice change.

Remember, regardless of age, in order to contribute to an IRA, you or your spouse must have earned income.

RMDs Begin at 72

For those attaining age 70 ½ after December 31, 2019, the age at which they will need to take RMDs will be 72, not 70 ½. This gives retirement accounts a bit more time to bake tax-deferred. It also slightly expands the window to do Roth conversions before RMDs begin. However, this last benefit is tempered by the fact that you must take Social Security no later than age 70. Roth conversion planning to reduce taxable RMDs should be mostly completed well before age 70 ½, regardless of this change in the law.

Note that taxpayers can still make qualified charitable distributions (“QCD”) starting when they turn age 70 ½. While pre-age 72 QCDs won’t satisfy RMD requirements, they will (a) help optimize charitable giving from a tax perspective (by keeping adjusted gross income lower and avoiding the requirement to itemize to deduct the contribution) and (b) reduce future RMDs.

Annuities in 401(k)s

The new law provides rules facilitating annuities in 401(k) plans. This one requires proceeding with extreme caution. If your 401(k) plan decides to offer annuity products, you need to carefully assess whether an annuity is the right investment for you and you need to fully understand the fees charged.

Remember, just because the law changed doesn’t mean your asset allocation should change!

Leaving Retirement Accounts to Heirs

This is the where the SECURE Act raises taxes. The SECURE Act removes the so-called “stretch” for many retirement plan beneficiaries. For retirement accounts inherited after December 31, 2019, only certain beneficiaries will be able to stretch out distributions over their remaining life (or based on the age of the decedent if over 70 ½ at death). For nonqualified beneficiaries, the rule will simply be that the beneficiary must take the account within 10 years of the owner’s death (the “10-year rule”).

My overall opinion on the SECURE Act stated above, planning for the next generation is important. Particularly if you are already financially independent and want to help your children become financially independent, the SECURE Act has significant ramifications.

Spouses

If your current estate plan features your spouse as your retirement account primary beneficiary, the SECURE Act should in no way change that aspect of your plan. Fortunately, the many advantages applicable to spouses inheriting retirement accounts will not change. Spouses remain an excellent candidate to inherit a retirement account.

Minor Children

If you leave your retirement account to your minor children, they are exempt from the 10-year rule (and can generally take distributions based on IRS RMD tables that are generous to younger beneficiaries) while they are still minors. Once your children reach the age of majority, they will have ten years to empty the retirement account.

The exception to the 10-year rule applies only to your minor children. It does not apply to your grandchildren, your adult children, and the children of others (including nieces and nephews).

Other Eligible Beneficiaries

The exceptions to the 10-year rule apply to your spouse, your minor children, the disabled, the chronically ill, and persons not more than 10 years younger than you at your death. All others will need to empty retirement accounts within 10 years of inheritance. This will require some significant planning in cases where the beneficiary has inherited a traditional retirement account to strategically empty the account over the 10 year window to manage adjusted gross income, taxable income, and total tax.

Planning

For those of you with estate plans involving adult children, the passage of the SECURE Act may well require revisions to your plans. First off, as a practical matter, your revocable living trust may need modifications. Many have designated a trust as a retirement account beneficiary. To do so properly requires conforming with specific income tax rules. Those with trusts as the beneficiary of their retirement account would be well advised to, at a minimum, consult with their lawyer to determine if the language of the trust needs updating.

Second, understanding that inheriting a traditional retirement account will now mean accelerated, and possibly significantly increased, taxation for their heirs, many will want to consider Roth conversion planning. Roth accounts will be subject to the 10-year rule, but the good news is that the beneficiary can keep the assets in the Roth account for 10 years, let it grow tax free, and then take out the money in 10 years tax free. Not too bad.

Roth conversion planning to optimize your heirs’ income tax picture is now even more important. However, it should not be done if it will impose a financial hardship on the account owner during their lifetime. The first priority should be securing the account owner’s retirement. Only if the account owner is financially secure should they consider Roth conversion planning to reduce their heirs’ tax liability.

Conclusion

Tax rules are always changing. This round of changes is a victory for those pursuing financial independence. Any tax law change that does not negatively impact your path to financial independence is a win.

For those considering the financial health of their heirs, particularly their adult children, the SECURE Act should prompt some reconsideration of estate plans. Often it is wise to consult with professional advisors in this regard.

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.

Tax-Efficient Charitable Giving

Introduction

Charitable giving is fantastic! Why not give some of your assets to improve a part of our world? And while you’re at it, why not save a few bucks in income taxes? As is to be expected, this requires some thoughtfulness. For some people, this can drive significant tax savings.

Lay of the Land after Tax Reform

The December 2017 tax reform legislation (often referred to as “tax reform,” the Tax Cuts and Jobs Act, or “TCJA”) significantly altered the landscape for claiming itemized deductions. For 2017, before tax reform became effective, the standard deduction for single taxpayers was $6,350 and $12,700 for married filing joint (“MFJ”) taxpayers. Thus, in order to claim itemized deductions, the taxpayer’s total itemized deductions (such as mortgage interest, state and local taxes, and charitable contributions) had to exceed these thresholds for the 2017 tax year. Many itemized simply because their state tax withholding alone put them in a position to equal or exceed these thresholds. This matters with respect to charitable contributions because if you don’t itemize, you don’t get any tax benefit for your charitable contributions.

Post tax reform, things are different. First, tax reform significantly increased the standard deduction. In 2018 the standard deduction increased to $12,000 for single taxpayers and $24,000 for MFJ taxpayers. Second, the deductible amount of state and local taxes (including individual income and property taxes) is capped at $10,000 per tax return. Thus, for MFJ filers and who paid $10,000 or more in state and local taxes still need $14,001 more in itemized deductions (mostly mortgage interest and charitable contributions) to itemize.

Thus, many will now find that they will take the standard deduction instead of itemizing. The downside is losing the tax benefits of charitable contributions. However, there are several planning opportunities whereby taxpayers can still reap significant income tax benefits of charitable contributions.

Donor Advised Fund (“DAF”)

Ideal for: People (a) with standard deductions very close to their itemized deduction amount or greater and (b) who makes regular, predictable (weekly, monthly, quarterly, or yearly) donations to charities or plan to donate to charities in the future.

How it Works and Tax Benefits: A donor establishes a donor advised fund with a financial institution that has established a charitable institution for the purpose of managing donor advised funds. The donor provides assets to the DAF. Then the donor “advises the fund,” meaning that he or she requests that the fund make disbursements to particular charities in particular amounts. While the institution in control of the DAF could, theoretically, reject the request, as a practical matter as long as the requested charity is a valid, properly registered section 501(c)(3) public charity, the DAF will send money to the charity. There is no explicit time requirement for the DAF to disburse its funds, and thus the DAF can make donations to public charities for several years.

The DAF gives the donor a significant tax benefit in today’s high standard deduction environment. The donor receives an upfront tax deduction for the fair market value of the assets contributed to the DAF in the year of the contribution. It is a way for a donor to bring forward, for tax purposes, the charitable deduction for contributions to a charity or charities occurring over several years. For tax purposes, the DAF aggregates several years’ worth of charitable contributions in a single year without a future tax cost, since the donor is covered by the high standard deduction in the later years when the DAF contributes to the charities.

Example: Jane and Joe Smith attend Mass every Sunday at St. Joseph’s Catholic Church. Every time they attend Mass they put money in the collection basket as a charitable donation. In November 2018 Jane and Joe add up their projected 2018 itemized deductions (mortgage interest, state taxes, and charitable contributions) and project that they are at $24,000, exactly the same as the standard deduction. They anticipate their itemized deductions in 2019 will only be $18,000. If they make a $5,000 contribution to a DAF in early December 2018, their 2018 itemized deductions will increase to $29,000. Going forward until the DAF is exhausted, the DAF will make disbursements to St. Joseph’s instead of the Smiths making the contributions.

The contribution to the DAF provides the Smiths a significant tax benefit in 2018 ($5,000 reduction to taxable income) and will cost them nothing in 2019, since they will take the standard deduction for 2019 regardless. Forgoing 2019 tax deductions (by accelerating them to 2018 through the DAF contribution) did not cost Jane and Joe Smith any additional tax in 2019 and saved them tax in 2018.

If Jane and Joe were initially at $18,000 in 2018 itemized deductions instead of at $24,000, a $5,000 DAF contribution would not have made sense, because the Smiths would not have enough itemized deductions ($23,000) to exceed the standard deduction.

Another DAF tax benefit for the donor is that income earned by the DAF (i.e., interest, dividends, and capital gains) is not taxable to the donor. That income increases the charitable impact of the original DAF contribution.

Some caveats: First, a transfer to a donor advised fund is an irrevocable transfer. While the donor retains the right to advise the DAF regarding disbursements to charities, the donor cannot reclaim the funds for him or herself. Second, the institution holding the DAF will charge fees against the DAF assets. Finally, institutions usually require a minimum initial contribution in order to form a DAF.

Donation of Appreciated Stock

Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds.

How It Works and Tax Benefits: Donations of appreciated securities to an eligible charity allow the donor to deduct the entire FMV of the stock, up to 30% of adjusted gross income (“AGI”). Alternatively the donor can elect to deduct the basis of the stock, up to 60% of AGI. Further, the donor avoids recognizing the capital gain on the securities on his or her tax return. Thus, this strategy has a benefit from an income perspective (avoids recognition of a gain) and a benefit from a deduction perspective (the itemized charitable deduction).

For those looking to get rid of securities that no longer fit their desired investment portfolio, this can be a very tax efficient manner to do so.

Note that built-in loss securities should not be donated to charities. Rather, they should be sold first in order to trigger the capital loss for tax purposes, and then the proceeds should be donated to the charity.

Hyper Donor Advised Fund

Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds that make routine charitable contributions or are interested in making future charitable contributions.

How It Works and Tax Benefits: The “hyper donor advised fund” (my pet name for this technique) simply combines the first two planning techniques.

Here is an example: Sammy owns 100 shares of Kramerica Industries. It is worth $50 per share ($5,000 total) and Sammy paid $5 per share ($500 total). Sammy has determined that he will have $11,000 of itemized deductions in 2018 and is likely to have no more than that in 2019 and 2020. Sammy plans to donate approximately $1,000 to his favorite charity, The Human Fund, annually.

Sammy can transfer the appreciated Kramerica stock to a DAF in December, 2018 and claim $16,000 of itemized deductions on his 2018 tax return without lowering his tax deductions in 2019 and 2020. Sammy also avoids recognizing on a tax return the $4,500 ($5,000 less $500 cost basis) gain he has in the Kramerica stock. The DAF can sell the Kramerica stock, invest the proceeds, and make, at Sammy’s recommendation, annual donations to The Human Fund.

Qualified Charitable Distribution (“QCD”)

Ideal for: (a) those 70 ½ or older and (b) those nearing age 70 ½ who cannot yet do a QCD, but should consider future QCDs when doing current tax planning.

How it Works and Tax Benefits: Donors 70 ½ years old and older can contribute up to $100,000 annually to charity directly from their traditional IRA without the amounts contributed being included in taxable income. The main advantage of this strategy is that the taxpayer’s “required minimum distribution” (“RMD”) can be satisfied by the QCD without a taxable income inclusion to the donor. While the donor does not receive a charitable deduction, that is made up for by excluding the amount of the QCD from taxable income. Given the new higher standard deduction, the taxpayer essentially gets the benefit of a charitable deduction without having to itemize.

While the QCD can satisfy the RMD, it does not have to – if a taxpayer has a RMD of $10,000 for the year but wants to make a $20,000 donation from their IRA to a charity, they can do so and the entire $20,000 amount qualifies for QCD treatment.

QCDs also present a planning opportunity for those not yet 70 ½ years old. Many do Roth Conversions (converting traditional IRAs and other traditional accounts to Roth IRAs) prior to age 70 ½ to reduce future RMDs. Doing so creates current taxable income, but lowers the future balance in the traditional IRA or 401(k) such that in the future RMDs are lower. For those charitably inclined, they may want to limit current Roth Conversions designed to mitigate future RMDs, since future QCDs can be used to eliminate the tax impact of RMDs in the future. Thus, charitably inclined individuals in their 60s may want to leave some amounts in traditional IRAs for future charitable donations. Then, when they turn 70 ½ they can make QCDs to avoid RMD taxable income.

It is important to note that to qualify for QCD treatment, the donor must be 70 ½ or older on the date of the distribution. Second, gifts to private foundations and DAFs do not qualify for QCD treatment. Third, inherited IRAs qualify for QCDs as long as the beneficiary inheriting the IRA is 70 ½ or older at the time of the distribution.

Lastly, the charity should never give any token gift of appreciation for the QCD donation because the receipt of anything in return for the donation disqualifies the distribution from favorable QCD tax treatment.

Bunching Contributions

Ideal for: Charitably inclined people with excess cash at year end.

How it Works and Tax Benefits: For taxpayers at or over the standard deduction threshold near year end, it may be advisable to make next year’s planned charitable donations this year to accelerate the tax deduction and take advantage of the next year’s higher standard deduction. Similar to some of the above techniques, the technique picks a year to itemize deduction and then picks a year (or years) to utilize the standard deduction in a manner the optimizes the total tax deductions taken over a period of time.

Charitable Remainder Trust

Ideal for: Wealthy charitably inclined people looking for a large current tax deduction, often in cases where they have a one-time significant income event, such as the sale of a significant asset or business or a very significant bonus.

How it Works and Tax Benefits: Taxpayers can contribute assets to a trust whereby the donor receives the income from the trust assets for a period of time and a designated charity receives the assets of the trust at the end of a period of years. This technique gives the donor a large upfront one-time deduction based on IRS rules.

This is generally not a strategy very applicable in the FI community, but for certain wealthy taxpayers looking for a significant tax deduction and willing to engage the right legal and tax professionals, it can create significant benefits.

Conclusion

Charitable giving illustrates the need to always consider whether there is a tax angle to a transaction. Contributions, if structured in particular way, can provide significant tax benefits while fulfilling their main purpose — the improvement of society and the advancement of the charity’s eleemosynary cause.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.