Tom Fridrich, JD, CLUⓇ, ChFCⓇ, Senior Wealth Planner
The end of the year offers an ideal opportunity to look both forward and back — reflecting on recent achievements, while setting goals for the upcoming months. For many of my clients, it’s also a time to review their finances and identify moves that can help protect their tax bills.
If you’ve had a particularly high-income year, you might be feeling especially confident about your finances, and yet facing the upcoming tax liability may come as a shock. Fortunately, there are several strategies that can combine two common money-related goals — reducing your tax burden while contributing to charity.
What Is a “High-Income” Year?
When we talk about a high-income year, we’re not referring just to a hefty raise from a promotion or a job change (although that is commendable and likely should invite some financial planning of its own). Here, we’re talking about an unusual, often one-time spike in your income.
For example, you might have finalized the sale of your business and received a sizable one-time cash payment, rather than an installment payment over several years. Or maybe you sold property at the height of the market and realized an appreciation that exceeded the capital gains exemption or wasn’t eligible for it. Or, you might have received an extraordinarily large bonus or want to exercise stock options that have recently vested.
What Are the Tax Consequences of an Income Spike?
Obviously, most people appreciate that the higher their income, the higher the tax bill. And with ordinary income that is typically expected.
However, if you’ve been affected by one of these significant events, it can be painful to pay the extra taxes, especially when you recognize that this money flowing into your account is not an ongoing event.
Furthermore, while direct taxes are one thing, it might also trigger indirect consequences. A high-income year could mean you phase out of income credits that are necessary for your day-to-day life. Or it may make you ineligible for the Biden-Harris Administration’s Student Debt Relief Plan, which is targeted only to those at a certain income threshold that you would otherwise qualify for.
If you’re on Medicare, a high-earning year can increase your health insurance costs and make you subject to what we call “Dear Aunt IRMAA,” which stands for “income-related monthly adjusted amount” and results in a surcharge in your Part B and Part D premiums.
What Are the Benefits of Giving to Charity in a High-Income Year?
Simultaneously, many people realize this windfall offers the chance to make a philanthropic donation in a way they’ve been unable to previously. Perhaps you’ve made smaller donations throughout the year or have tithed faithfully to a religious organization, but never felt as though you were in the position to make a more substantial gift — until now.
Thanks to this financial event, you can now make a bigger impact, while also reaping tax advantages.
What Are Some Ways You Can Give to Charity in this High-Income Year?
While you obviously could always make a direct cash gift to the organization of your choice, there are some other vehicles that might offer additional benefits. Here are three to consider:
- Donor-advised fund (DAF)
With a DAF, you make a charitable contribution to a fund that is held in a custodial account. While you make the donation and receive the tax deduction for the entire sum today, you don’t have to select the end charities or how you want to allocate your funds. The money can sit in the DAF until you’ve determined where and at what pace you’d like to donate. Since the assets can still be invested, they may continue to grow for an even bigger impact.
A DAF is appealing because rather than making an immediate generous contribution to a group, you have the latitude to do more research or give a smaller amount and evaluate how the organization uses its money. I also see clients using it as a way to introduce their children to a philanthropic mindset by inviting them to be part of an annual conversation about where they’d like to donate.
You also can donate assets other than cash to a DAF, which makes them favorable for clients who have realized large stock gains. For example, if they purchased a portfolio for $10,000 that’s now worth $100,000, they can donate the appreciated portfolio and avoid capital gains, while getting the deduction for the entire fair market value of $100,000.
- Qualified charitable distribution (QCD)
Clients who do not need the Required Minimum Distributions (RMD) from their 401(k) or individual retirement account (IRA) can donate it to charity and get the tax benefit as a QCD. This is especially useful for clients who take the standard deduction rather than itemizing, which would mean they otherwise wouldn’t get tax relief.
While it might be too late to deploy this strategy this year, it’s something to consider for 2023. Because your RMD is based on your account value as of December 31 of the prior year, we can come close to predicting what your future RMD will be and begin to plan the right strategies, including potentially donating it to avoid unexpected taxes.
- Charitable gift annuity
If you want to make a considerable donation now, but would benefit from receiving future income, you could look into a charitable gift annuity. This is a contract between you and the charity where you make a bequest, which provides a tax deduction, and then you also receive a stream of income from the charity. In return, the charity receives the asset up front and can use it immediately. However, not all nonprofits will accept this type of gift because it can be more involved to set up a payment stream. You can visit the American Council on Gift Annuities to find out more about how charitable gift annuities work and search for member organizations by name, type or geographic location.
With a charitable gift annuity, you claim taxes for the amount, minus the value of the payments that will eventually be made. So if you donate $30,000 with the expectation that $20,000 is the donation and the remaining $10,000 will be returned in payments, you would deduct the $20,000.
Professional Advice Can Help You Make the Right Moves
While reducing your tax bill by donating to charity is an admirable act and often a wise financial strategy, always talk to a financial advisor before making any decisions. Since every person’s situation is different, they can help you assess the tax risks and advantages and discuss options that align with your current financial position and goals.
Tom Fridrich is not affiliated with Cetera Advisor Networks LLC.
Generally, a donor advised fund is a separately identified fund or account that is maintained and operated by a section 501(c)(3) organization, which is called a sponsoring organization. Each account is composed of contributions made by individual donors. Once the donor makes the contribution, the organization has legal control over it. However, the donor, or the donor’s representative, retains advisory privileges with respect to the distribution of funds and the investment of assets in the account. Donors take a tax deduction for all contributions at the time they are made, even though the money may not be dispersed to a charity until much later.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.