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Morningstar's resident tax guru, Sheryl Rowling, describes the conventional method of making charitable contributions as "kind of a break-even" from a tax standpoint. If an individual writes a check to charity, she can deduct the contribution on her taxes, assuming she itemizes, but she's contributing dollars that have already been taxed.
Of course, contributing to a charity and claiming a deduction is better for your tax return than, say, spending the money on yourself--not to mention the psychic boost you're apt to gain from contributing to a good cause. But charitable strategies involving investments have the potential to deliver greater tax benefits than making plain-vanilla cash contributions. Tying those donations in with a portfolio maintenance regimen can also help improve your portfolio's risk/reward potential.
You might assume that investment-related charitable-giving strategies are strictly for the Neiman Marcus/Range Rover set, but that's not the case. Strategies like taking qualified charitable distribution, donating appreciated securities, and employing donor-advised funds can be useful for smaller investors, too. As 2016 winds down and talk of charitable giving before year-end heats up, here are some of the key portfolios maneuvers to consider instead of simply writing checks from your taxable account.
Qualified Charitable Distributions
The Maneuver: Investors older than age 70 1/2 who are taking required minimum distributions from their traditional IRAs and 401(k)s can steer a portion of their distributions--up to $100,000--directly to the qualified charities of their choice, thereby satisfying the required minimum distribution requirements. The virtue of having your IRA administrator cut a check to the charity--rather than taking the RMD, depositing it in your account, writing the check to charity, and deducting it on your tax return--is that the qualified charitable distribution, unlike an RMD, doesn't inflate your adjusted gross income. That can help keep you out of a higher tax bracket, qualify you for credits and deductions that you might not be eligible for with a higher adjusted gross income, and reduce the amount of your Social Security income that's taxable. In years past, retirees' ability to take advantage of a qualified charitable distribution was dependent on Congress greenlighting the maneuver at the end of each calendar year. But in late 2015 President Barack Obama signed legislation making the qualified charitable distribution permanent.
Best for: Charitably inclined retirees who are required to take RMDs but don't need all of the money.
Extra points if: Retirees can also improve their portfolios' positioning by strategically pruning their RMDs from holdings that have grown too large and/or are overvalued; once they've liquidated or reduced the position, they can then direct the proceeds to charity via the qualified charitable distribution.
Donating Appreciated Securities
The Maneuver: Whereas qualified charitable distributions are appropriate for older investors who have much of their wealth in their tax-deferred accounts, donating appreciated securities will mainly benefit investors with taxable (nonretirement) holdings. This strategy can yield three key benefits. First, scaling back large positions by donating them to charity can help reduce a portfolio's risk level. Donating appreciated securities carries valuable tax savings, too--namely, the donor won't owe capital gains taxes on the appreciation in the shares, and he or she can deduct the full market value of the shares at the time of the donation, provided the investor has owned them for up to one year and provided the deduction is less than 30% of adjusted gross income. If the amount of donation exceeds what's deductible in a given year, any excess can be carried forward and deducted for up to five years in the future.
Best for: Investors who have highly concentrated positions in individual holdings with a low cost basis.
Extra points if: As with the qualified charitable distribution, donating highly appreciated assets helps can help reduce risk in a portfolio at the same time it yields a tax benefit. For example, perhaps you've run an X-ray on your portfolio and determined that you have way too much riding on the healthcare sector, thanks largely to a healthcare sector fund that overlaps heavily with broad-market exposure in your portfolio. You could donate all or a chunk of the healthcare fund to charity, thereby reducing risk in your portfolio while also enjoying a tax benefit.
The Maneuver: Employing a donor-advised fund is what Rowling has called a "super-charged" charitable-giving strategy. The donor contributes cash or investment assets to the fund, which is a charity in the eyes of the IRS, thereby obtaining an immediate tax deduction on the amount contributed. (If the donor contributes cash, he or she can take a deduction of up to 50% of adjusted gross income; if the donor contributes securities, the deduction is limited to 30% of adjusted gross income.) The donor can then direct contributions from the donor-advised fund to various charities over time, and can also contribute additional monies to the donor-advised fund. The donor is also in charge of how the money is invested; most donor-advised funds feature a short menu of investment options ranging from very conservative (for monies that will be disbursed soon) to more aggressive (for assets that will be distributed to charity further in the future). The contributions are irrevocable, which is why the donor can obtain the tax benefit right out of the box, even though the amount isn't necessarily being disbursed straightaway. As with donating appreciated securities directly to a charity, investors can steer highly appreciated assets into the donor-advised fund, thereby removing the tax burden associated with the embedded capital gain from their portfolios. (The charity does the selling, not the investor.)
Best for: Investors who find themselves in a particularly high-income year may benefit from employing a donor-advised fund; it enables them to obtain the tax break in that year but move deliberately to donate that money to charity over a period of months or years. Donor-advised funds may be particularly appropriate for investors with nonpublicly traded assets, like stock of private companies. Many charities can handle donations of publicly traded securities, as in the maneuver outlined above; the charity can simply liquidate the position in the open market and direct the proceeds back into the charity. But most charities are not equipped to deal with nonpublic assets; donor-advised fund administrators have more experience with assets such as restricted stock and ownership stakes in nonpublic companies.
Extra points if: As with qualified charitable distributions and donating appreciated securities, investors can employ a donor-advised fund to improve their portfolios' risk/reward characteristics. Donating nonpublic assets to a donor-advised fund can also simplify the administration of a donor's estate, in that heirs won't be required to find a buyer for those assets, while removing those highly idiosyncratic, often highly risk, assets from the investor's portfolio.
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