The Roth IRAs will grow tax free if they do not take any distributions for five years from the first conversion. To start the five years running, they did a small $1000 Roth conversion last year while they were still working.
To make their lives simpler, a second IRA withdrawal is being done at the end of the year—with federal and state income taxes being withheld from the IRA distributions for the total estimated tax they will owe each year. This allows them to not worry about making quarterly estimated tax payments.
4. Donate Appreciated Securities, Not Cash
Many people are in their highest tax brackets in the last five years of the accumulation phase. This may occur due to high earnings years or from selling a business. This is a great time to set up and fund a Donor Advised Fund (DAF), for which you receive the charitable deduction upon setup. Community foundations were the first organizations to offer DAFs. Today, financial institutions, such as Schwab, Fidelity and Vanguard, as well as charities, offer DAFs. DAFs vary mostly in terms of their minimum contribution, minimum grant, investment options and fees. Service is also a consideration. For example, a community foundation offers a hands-on connection to local needs and initiatives.
The DAF can be used to fulfill your charitable intentions after the accumulation phase. A DAF can also be used to get children involved each year in the charitable decision-making process, teaching them your family’s values and giving them a reason to get together on a regular basis.
Randy and Katie plan to give $50,000, over a five-year timeframe, to a non-profit for which Katie serves on the board of directors. They have highly appreciated securities in a living trust and were planning on selling investments to raise cash for the contribution. In lieu of donating cash, it was recommended they donate the appreciated securities approximating $50,000 into a DAF. Their tax situation, and this strategy, will allow them to fully deduct the contribution over the next couple years and avoids having to report capital gains on their tax return this year. The DAF will immediately sell the securities they received, reinvest the proceeds appropriately, and at Randy and Katie’s direction each year, forward the cash to the non-profit.
5. Donating Traditional IRA Assets To Charity After 70½
Dan and Kathy are married and both are age 73. They expect to have income of $285,000 from Social Security, required distributions from their IRAs, and more than $50,000 of taxable interest, dividends, and capital gains. Over the last few years, since they started taking their required minimum distributions (RMDs) from their IRA accounts, Dan and Kathy have exceeded the $250,000 threshold for the net investment income tax. Thus, they have had to pay an extra 3.8 percent tax on some of their investment income.
In reviewing the 2018 tax brackets they noted that their marginal tax bracket will go down from 33 percent to 24 percent. However, their only deductions for itemizing would now be $10,000 for state and local taxes, plus about $5,000 that they give annually to charity, for a total of $15,000 of itemized deductions. This amount is less than the new standard deduction. As a result they would no longer itemize. With advice from their advisor, Dan and Kathy decide to use what are called Qualified Charitable Distributions (QCDs) to gift to their charities directly from their IRA accounts. While the charitable donations count towards Dan and Kathy’s RMDs, they are not reported as income on their tax return.
From a tax perspective, this has two benefits. First, not reporting the donations as income has virtually the same benefit as they used to get by reporting the income and then deducting the amount as an itemized deduction. Now they can still claim the standard deduction, allowing them to get the tax benefit for their charitable contributions on top of the standard deduction. The second benefit is that since the $5,000 of QCDs count towards their RMDs, but are not reported as income, $5,000 of their investment income now falls below the Net Investment Income Tax threshold. This saves Dan and Kathy an extra 3.8 percent in tax on that $5,000. Thus, by making $5,000 of QCDs, Dan and Kathy save 27.8 percent in taxes, or $1,390.