Best Tax-Efficient Ways to Give to Charity
What are the best ways to leave money Charity?
This post is part two of a two-part series. Part 1 addresses how to leave money to your children.
Now, let’s look at the best ways to leave your money charity! What are the optimal and most tax-efficient ways you can leave your money?
There are only 4 things you can do with money: spend it, give it away, invest it, or leverage it.
Let’s give some money away!
What’s the Maximal Withdrawal Rate you can Give?
Let’s start with a basic concept. How much money can a squeeze out of a retirement account?
Usually, we talk about the 4% safe withdrawal rate. What if you wanted to bounce the last check to the undertaker so you have more money to give away during your life? How much can you take if you want to spend down all of your assets to give away? Note, this isn’t the most tax-efficient way to give but let’s start here.
If you have a $1M portfolio, it is generally safe to withdrawal $40,000 the first year and adjust that dollar amount for inflation.
In figure 1, you can see a 4% ($3334 a month) drawdown in light green vs a 6.7% ($5566 a month) in dark green.
In this situation, you can get 2.7% more per year, or $2233 a month ($26,805 a year) out of a nest egg over 30 years, leaving you with zero at the end. So, out of a $1M nest egg over 30 years, you can leave more to charity while you are still alive!
How Can We Squeeze Even More Money to leave to Charity? Use Tax-Efficient Giving!
If you did take this higher drawdown, taxes are a huge! We must tax-optimize charitable giving!
Early retirement is the best time to manage your taxes. The Tax Planning Window for retirement opens up when you retire and closes when you start taking social security.
Let’s look at the tax implications of a high drawdown percentage.
Optimize Taxes in Early Retirement in order to Give more
If you pay less in taxes, you get to give the money you save! This is Tax-Efficient Giving!
Most often for retirement income you draw from the brokerage account first. This allows time for the tax-deferred (IRA) and tax-free (Roth) accounts to grow.
Even more important, however, is utilizing the standard deduction and your 10 and 12% tax brackets to pay less in taxes overall over time.
Let me say that again. The best way to maximize tax-efficiency is to take advantage of the standard deduction and the low tax brackets to extract pre-tax funds.
Let’s return to Figure 1: on the bottom you take income from your IRA first (orange).
Note during this time you also receive dividends and interest from your brokerage account (light blue), but do not sell and recognize capital gains (darker blue not seen). The total income needed here is about $60,000 a year compared to $100,000 at the peak in the top graph.
Now, this is where the magic happens. When you turn 70, you don’t have any IRA left! You are not forced to pay taxes on tax-deferred income.
This has several implications. First, Social Security (lime green) is taxed minimally as there is negligible income from the brokerage account (light blue). Second, you pay decreasing rates of taxes between ages 70-80. Finally, you pay no taxes after 80 when only the Roth remains.
The bottom line: you save over $70k in taxes during your lifetime and wind up with an additional $70k at the end. This extra $140k during your life is a 14% return on your original $1M nest egg: not a bad return for understanding tax planning!
So, if you want to give as much as possible in retirement, be as tax-efficient as possible especially during your Tax Planning Window.
The Tax Planning Window Helps with Tax-Efficient Giving
The elephant in the room: the always-tax IRA.
The goal: convert this Always-Taxable reservoir into income while paying the least in tax over your lifetime. This is why your standard deduction, 10% and 12% tax brackets are so important!
The order in which you withdrawal from these accounts is of vital importance during your Tax Planning Window.
How to Utilize Low Tax Brackets in the Tax Planning Window
Let’s explore the different ways you can utilize your Tax Planning Window to Maximize Tax-efficiency.
In this case, partial Roth conversions don’t make sense. In fact, if your goal is giving to charity, don’t bother with Roth accounts at all! This is an important point.
Roths are best for giving to heirs, but not optimal for charity since you have already paid taxes! Spend the Roth accounts in retirement when you need tax-free income (such as to keep surcharges on Medicare or IRMAA away).
Capital Gain Harvesting is an idea. You can harvest gains up to the 12% tax bracket max and pay 0% capital gain tax. Capital gains and qualified dividends sit on top of your ordinary income to fill the 0, 15, 18.8 and 23.8% capital gains brackets.
If your total taxable income is below the 12% tax bracket, that any qualified dividends included in that base are taxed at zero. Any qualified dividends above that base begin to be taxed at 15% and go next not to the 20% tax bracket (but hit NIIT first at 18.8%).
The ideal solution, however, is to use an elephant gun against the IRA. Recognize Always-Taxable income at 10 or 12% tax rate before you are forced into taking social security and suffer the tax torpedo.
So, in summary, you can use tax planning to improve the amount of money you have to give. Remember, in the end, it is how much money you have after taxes that counts!
Tax-efficient giving during your life involves tax planning during your tax planning window. What are some other ways to give?
What if You Want to Give Away as Much as Possible?
Giving is more difficult since the Tax Cut and Jobs Act increased the standard deduction and limited SALT deductions. Creativity when giving is important, especially in retirement when no longer earning income.
You can lump donations every other year (in order to get above the standard deduction), or better yet consider a donor advised fund (DAF). Combine a DAF with a tax-generating event such as Capital Gain Harvesting or partial Roth conversions for maximal effect.
In general, don’t give cash. With cash, you can get up to a 60% deduction on your AGI, which is nice.
It is better, however, to give appreciated assets such as stocks, real estate or other assets. You only can take up to a 30% deduction on your AGI with appreciated assets. Just as important, however, you don’t have to pay taxes on the appreciation.
Never give Roth money as you have already paid taxes!
Perhaps, the best money to give is from your IRA.
Tax-Efficient Giving from your IRA
Since the income in your IRA is Always-Taxable, you can forgo paying taxes if you give your IRA to charity. Options include beneficiary forms, QCDs, or-if you need income- a CRUT.
IRA Beneficiary Forms
Remember, IRAs pass outside of wills and probate via a beneficiary form. Spouses have the most options for inherited IRAs. They can make the IRA their own, or take RMDs on their or their spouse’s life expectancy.
Charities can be beneficiaries as well. They don’t pay taxes on this money, however! Charities can use the entire amount of the IRA, so giving IRAs to charities is extremely tax-efficient.
If you leave your spouse as primary beneficiary and a charity as a contingent, you give your spouse the ability to disclaim the IRA and give it to charity if he or she doesn’t need the money.
Beneficiary forms are important and powerful. Don’t ignore them!
Qualified Charitable Distributions
Qualified charitable distributions (QCDs) are a great way to get rid of unneeded RMDs. First off, you must use RMDs rather than non-RMD distributions so you can only do this once you are 70 and a half years old. Also, RMDs must come out first, so don’t take a distribution and then try to do a QCD!
Do a trustee-to-trustee transfer of the distribution and you need not report the distribution as income. Do be careful around tax time, however, as the 1099 from your IRA does not specify that the distribution went to charity or to your bank account. Make sure your CPA knows not to include the distribution as income.
The reason for QCDs: if you take the distribution and then donate it, you may get no tax benefit due to the large standard deduction!
Instead, give the money away before it is recognized as income.
But what if you need the income?
Charitable Gifts with Income
You can leave your IRA to charities via the beneficiary form.
Or, you can give your IRA to charity and still benefit from income during your lifetime. Many charities and universities are more than happy to help you donate. They can set you up in a pooled income fund, a gift annuity, a foundation, or a charitable remainder uni-trust (CRUT). Discussion of pros and cons of each of these are beyond the scope of this piece, but let’s look quickly at a CRUT.
CRUT for Income and Tax-Efficient Giving
When you donate your IRA into a CRUT, you will not pay taxes and the full amount of the donation will go into an irrevocable trust that is then invested for tax-free growth.
The income you receive from the trust is actuarily set up in advance. You must plan on leaving at least 10% of the gift to charity, and you get a current write off on the present value of that future gift. That’s a mouthful. You deduct the future gift now, discounted for its value in the future.
Typically, you can get 5-8% of your donation back as income every year. Meanwhile, the full donation (not just the after-tax part) is in trust and grows tax-free.
Let’s look at giving away the IRA at retirement to a CRUT with a 6% payout.
IRA CRUT and Tax-Efficient Giving
Feel free to skip over this section if you want! It gets pretty wonky from here until the conclusion.
With the IRA CRUT, income from the payments are fully taxable. The donation stems from an Always-Taxable account, so the income retains its tax nature.
On top of figure 3 is a comparison for both a portfolio with and without a 6% IRA CRUT.
In light green, this is the 6.7% withdrawal rate from Figure 1.
Dark green is the CRUT. Note the decrease in portfolio value when you fund the CRUT. Over time, the slope is less steep due to the income from the CRUT. Please remember, though, this is just a comparison of portfolio size! With the CRUT, you continue to receive income while you are alive!
On the bottom: the key tax components of the CRUT. Compare this with Figure 2.
In blue, note the income from the CRUT as a component of taxable income stays stable over time.
In green, qualified dividends and interest provide the rest of the income until age 70.
After 70, taxation from social security and from capital gains on the brokerage account slowly increase over time.
Note that you don’t really have more money with a CRUT than if you invest your IRA over time. You do, however, decrease market risk, tax risk, and longevity risk with this donation to charity.
Conclusions: Tax-Efficient Charitable Giving
Tax-Efficient Giving is hard work!
If you understand taxation and the Tax Planning Window, you have a leg up. Every dollar you don’t pay in taxes you get to give away.
Always-Taxable IRA accounts are the trickiest to plan. Give them to charity if you can.
Otherwise, if you chose between uncle Sam and a charity… well, I know who I would chose every time!