Updated: Dec 5, 2022
Donor Advised Funds (or DAFs) are an increasingly popular way to make charitable donations to 501(c)(3) organizations. The reasons for their popularity include:
· Being able to donate to the DAF today and recommend which charity (or charities) receive the funds in the future
· Receiving a charitable tax deduction in the year that you give to the DAF, not in the year that you distribute the funds to the charity (note: in order to utilize the deduction, you must itemize your deductions rather than take the standard deduction)
· Investing undistributed funds while they remain in the DAF
· Last, by not least, there can be significant tax advantages when you donate appreciated stock rather than cash to your DAF
Regarding the last point, let’s look at an example. We’ll assume you bought a share of stock for $50 and you held it until it reached $100 today.
Also, we’ll assume the highest marginal tax rates apply:
· Federal ordinary income of 37%
· California state income state of 12.3% (applicable to both ordinary and capital gains)
· Federal long-term capital gains of 20%
· Federal investment income tax (ACA tax) on sale of stock of 3.8%
When you donate to charity (or a DAF) you receive a tax deduction in the amount of the donation. You receive the same tax deduction whether you donate $100 of cash or a $100 of stock. However, when you donate appreciated stock, you never pay the tax on the capital gain, which is why donating appreciated stock is usually better than donating cash.
Let’s compare the two options using the assumptions.
As shown in the table below, donating $100 cash (Option 1) will actually cost you $50.70 since you save $49.30 in taxes from the charitable tax deduction. But what if you donate $100 of the appreciated stock (Option 2)? You still receive the same charitable tax deduction, but you also avoid the tax on the capital gain of $18.05. When you add those two benefits, the cost of donating the stock goes down to $32.65. The difference is the result of avoiding the capital gains tax!
Now, what if you assume you donate stock that has appreciated less and lower marginal tax brackets? These assumptions would reduce the tax benefit of donating the appreciated stock. But the larger point still remains: donating appreciated stock is usually more tax efficient than donating cash because you’re avoiding the tax on the gain (assuming you don't exceed the limitations on stock donations).
You can read more about DAFs here. Let us know if you’d like to further discuss all the benefits of opening a DAF and/or gifting strategies to maximize the tax benefits.
Setarcos Wealth Advisors LLC (“Setarcos”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Setarcos and its representatives are properly licensed or exempt from licensure.
The information provided above is for educational and informational purposes only and does not constitute tax advice and it should not be relied on as such. Setarcos and its advisors do not provide legal, accounting, or tax advice. Consult your attorney or tax professional.
Market declines are painful. When they happen (as they are today), you’ll often see recommendations to take advantage of the decline (e.g., tax-loss harvesting). Most of these recommendations are value-adding, however, we often see one with which we disagree: to do a Roth conversion after a market decline.
To make our view on this clear: we do not recommend converting your traditional IRA money to Roth IRA money (i.e., doing a ‘Roth conversion’) solely because markets have declined.
To understand why, let’s first consider the reasoning often used to justify the recommendation to convert in a market decline. It goes like this: when markets decline, your IRA balance is lower today than it was before the market fell; therefore if you convert today, you will pay less in tax dollars than if you converted before the market fell. This is true, but it does not justify a conversion. The focus of a conversion should be on tax rates not dollars paid. If dollars paid were the reason to convert, the following conclusion would be reached:
· If the goal is to minimize the tax dollars paid on conversion, then you should convert today if you think your IRA balance might ever be higher
· Therefore, since you will obviously assume your IRA balance will grow in the future, you should convert all your IRA money today and never hold traditional IRA money (even if the market didn’t decline!)
To be clear, again, we don’t recommend doing this.
In fact, where the market has been in the past has no bearing on the Roth conversion decision. Instead, the primary driver of this decision is a comparison of your current and future tax rates. Paying less taxes today when the market declines will still be worse economically if your tax rate today is higher than the future. To help illustrate why, let’s first back up and review the tax benefits of IRA accounts and how those relate to Roth conversions.
There are two types of Individual Retirement Accounts (or IRAs): Traditional IRAs (which consist of pre-tax money) and Roth IRAs (which consist of after-tax money). When you contribute to a Traditional IRA, you receive a tax deduction and the account grows tax-deferred. When you eventually take a withdrawal, you’ll owe taxes based on your marginal tax rate in the year of withdrawal. A Roth IRA works in the opposite way. There’s no tax deduction when you contribute, but the account growth and withdrawals are tax free.
If you’re in a higher tax bracket today compared to your estimated tax rate in the future when you plan to make withdrawals, it makes sense to contribute to a Traditional IRA (assuming you’re eligible). For example, if you’re in the 32% tax bracket today and estimated to be in the 22% bracket in the future, you’ll save 10 cents on every dollar you contribute. In other words, for every $1 you contribute today you’ll avoid 32 cents in taxes and then pay 22 cents in taxes when you make a withdrawal – that’s a net 10 percent savings!
If you’re in a lower tax bracket today than you would be in the future, a Roth makes sense. For example, if your marginal tax rate is 22% today but will be 32% in the future, you’d be better off making a Roth contribution (forgo a deduction worth 22 cents for every $1 you contribute) while avoiding taxes in the future (32 cents). Again, you’ll save a net 10 percent if you do this correctly.
For most wage earners near the middle or end of their career, their tax rate will likely be higher while they’re working than when they retire and have lower income.
Now, let’s pivot to Roth conversions, which is transferring funds from your Traditional IRA to your Roth IRA and paying the taxes today to avoid them in the future. The same tax rate logic applies to the decision about whether to do a conversion. If you go back to my example in the previous paragraphs, paying taxes today makes sense when you are in a lower tax bracket than you expect to be in the future. If you’re in a higher tax bracket today than in the future, your savings becomes a loss. Finally, if you’re in the same tax bracket, you’d be indifferent.
As I also said, people are generally in higher tax brackets while they are working. So, converting tends to be a great strategy when you stop working and before you start taking Social Security. For example, if you’ve retired at age 60 and Social Security benefits won’t start until age 67 or 70, then you can likely convert at very low rates!
Throughout this explanation, notice that I haven’t said anything about where the market has been and whether your balance is higher or lower than it used to be. Again, that doesn’t impact this decision. Michael Kitces, an advisor to advisors, has written about this concept here:
There are only four factors that impact the wealth outcome when choosing between a Roth or traditional IRA (or other retirement account). They are: current vs future tax rates, the impact of required minimum distributions, the opportunity to avoid using up the contribution limit with an embedded tax liability, and the impact of state (but not Federal) estate taxes… By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates… The principle of this equation is remarkably straightforward - the greatest wealth is created by paying taxes when the rates are lowest.
Again, to put it simply, you should not do a Roth conversion just because your IRA balance is lower today than it was at some point in the past (all other things unchanged). In fact, if you weren’t planning on doing a Roth conversion before the market declined, doing a Roth conversion because markets have declined can actually cause permanent financial loss.
That final point is worth emphasizing. Investors can make an IRA conversion even worse if the amount they convert pushes them into a higher tax bracket. If, for example, you do a Roth conversion this year because markets are down, but that conversion pushes your tax rate up when your tax rate today is already higher than what you expect in the future, then you’ve paid an additional tax you never needed to pay. We’re pretty sure no one wants that outcome!
In summary, here’s what you should keep in mind when you hear about Roth conversions:
· Don’t do a Roth conversion just because markets have declined
· Converting too much may needlessly push you into a higher tax bracket and result in economic loss
· They are tricky since they require building a financial plan that estimates your tax rate today versus your tax rate in the future
· They are a valuable tax strategy when it makes sense to do them
· You’ll likely have an opportunity to do them at some point so be patient and make sure you’ve evaluated your current and projected tax situation beforehand
As always, please reach out if you’d like to discuss.
Setarcos Wealth Advisors LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.