At Cordant, our primary role is to help our clients maximize the probability of reaching their objectives. While straightforward, the challenge is making recommendations in the face of uncertainty—the most obvious being the direction of the capital markets (stocks and bonds) in the short-term.  I have strong conviction, based off of historical information, that in the long-run, things will continue to go up. But, for this week or this month, your guess is as good as mine.

However, one area we have a little more control over is tax planning. Sure, there’s some uncertainty in this area as well, but focusing on what we can control will continue to lead us to better outcomes. For this reason, I’m going to highlight some actionable steps that can be taken for those that are charitably inclined and looking to optimize their itemized deductions.

The Changes

Before we get into the actionable items that might be of use, let’s first set the stage with the key changes that took place as a result of the implementation of the Tax Cuts and Jobs Act. The obvious headliner was that tax rates were lowered across the board. This change will mostly result in less taxes paid, per level of taxable income. The chart below, courtesy of industry expert Michael Kitces, provides a breakdown of the new tax rates compared to the old, for both individuals and joint filers, and shows per level of taxable income, if the taxpayer will be better or worse off. For any combination of marginal tax rate and taxable income, the green signifies the tax payer being better off, red being worse off and white being neutral.

You’ll notice that per unit of taxable income, most people will be paying less in taxes. Of course, generally speaking, keeping more of your money is typically viewed as a good thing. Unfortunately, the fun doesn’t stop there. The next section will focus on changes that have effectively increased the amount of taxable income for taxpayers that have elected to itemize their deductions (vs taking the Standard Deduction) in previous years.

Deductions and Exemptions

As depicted in the chart below, the new law completely eliminated the personal exemption and increased the standard deduction amount. You can see a breakdown here:

As shown above in orange, the new standard deduction ($12k for Individuals and $24k for couples) is greater than the combination of the standard deduction and personal exemptions previously allowed.

The next key change is the reduction in itemized deductions. Below are the key changes:

• Mortgage Deduction is only allowed up to $750k in mortgage (previously $1mm)
• State and Local taxes, and Real Estate tax (referred to as SALT) are capped at $10,000 (previously no limit)
• Advisory Fees (Tax and Investment) are no longer deductible under Miscellaneous fees

The result of the above changes is that high income earners that live in high income tax states (i.e. OR & CA), own a home, and/or engage with advisory services, have lost significant deductions that previously were helpful in reducing their taxable income and ultimately, taxes paid.

“Lost” Charitable Giving

With the standard deduction amount raised, and the expenses eligible for itemized deductions lowered, many more Americans will now opt for the standard deduction. And while this could make tax planning easier, it has brought to the forefront the one key deduction that is both unchanged by the new tax law and controllable by the taxpayer – charitable giving.

Going forward, the one unexpected implication of all the changes discussed above is that for those charitably inclined and now opting for the standard deduction, their charitable contribution will be “lost” from a tax perspective. Let’s use an example to illustrate what I mean by this.

In the below example, let’s assume a married couple has the following key itemized deductions for 2018:

• Eligible Itemized Deductions:
  • SALT (State, Local and Real Estate taxes) – $10,000
  • Mortgage Interest – $7,000
  • Charitable Contributions – $5,000
  • Total – $22,000

As you’ll see in the below hypothetical illustration, because the total deductions will be less than the standard deduction, the tax payer would opt for the Standard Deduction in this case and “lose” the $5k charitable contribution.

Controlling Charitable Deductions with a Donor Advised Fund (DAF)

For those who are philanthropic and are likely to opt for the Standard Deduction, you’re now hopefully asking yourself what can be done to capture the taxable benefit of your charitable gift. The answer lies in the utilization of a DAF. We’ve written more about DAFs as a helpful tax strategy for those looking at retirement, but here are the essentials:

• Open a Charitable fund in your name
• Contributions to the fund are deductible in the year received
• Assets can be invested and grow tax-free
• Grants can be made to charities at any time in the future

The beauty of the DAF is that you can frontload multiple years of giving and receive the entire deduction in that year, and then make grants to charities in the following years as you wish. By doing this, you can maximize your deductions every couple of years, leading to “lumpy” deductions and optimization of your charitable contributions.

Expanding on the previous example, instead of making your yearly charitable contributions, the below hypothetical example assumes you “front load” 4 years’ (timeframe is arbitrary) of giving into the DAF in 2018, and then compares this strategy to the traditional approach.

By frontloading the charitable giving and utilizing the “Lumpy Deductions” strategy, you can increase your total deductions over 4 years by $13,000 for the same amount of charitable giving ($20,000). Assuming a marginal tax rate of 35%, the additional $13,000 of deductions roughly equates to a tax savings of $4,550 over 4 years.

More, by gifting appreciated securities (i.e. S&P 500 fund) to the DAF, you will avoid paying capital gains taxes. Using the example above, if you gifted $20,000 of stock that was purchased for $10,000, the additional tax benefit would be roughly ($10k x 20%) $2,000.

Conclusion

It should be noted that executing on the above strategy won’t make up for a lifetime of lousy savings or poor investment decisions. That said, it’s these types of strategies that are well-within our control as investors that, repeated consistently, can lead to better outcomes over time. If you feel like you could benefit from tax planning, please don’t hesitate to contact us.

 

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