As 2020 gives way to 2021, here’s what you need to know about tax planning.
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I think we all wish we could have $10 for every time the word ‘unprecedented’ is used in 2020. It’s been a year of incredible upheaval and rapid change. I know I’ve been gobsmacked more times than I care to admit by the wild vicissitudes in which we’ve found ourselves, and frankly, the speed at which these changes have thrust themselves upon us. To sum up: 2020 has included a pandemic, massive unemployment, Congressional disarray, new tax rules, and weirdly enough, a stock market that seems oblivious to reality, at least in some sectors.
On one hand, some stocks seem to be on fire, like AMZN, up 70.4% through October, or APPL, up 57.75%. Similarly, there are funds and ETFs making hay on this bifurcated market. Just about anything in the large cap growth space, like Fidelity Advisor Growth Opps Z (FZAHX up 51.3%) or Lord Abbett Growth Leaders F (LGLFX up 61.8%) are up as well. We suspect that:
- Some of these gains may be unsustainable
- Tax rules may change and likely will prior to the expiration of Tax Cuts and Jobs Act (TCJA). This may include:
This leads to an interesting 2020 question: What do we do with some unprecedented gains in a strange year with potential tax increases on the horizon? The answer: we can harvest gains, by simply taking them or offsetting them against losses, or we can temper gains, by offsetting them with other forms of income and making charitable contributions. I’ll cover the latter in this piece, and I’ll cover harvesting gains in a later piece. Gain tempering can take many forms, but I’ll cover two:
- Charitable swaps, where you donate a highly appreciated security to a charity or Donor Advisor Fund (DAF), and buy it back, maybe in a Roth IRA.
- Roth charity offset, where you offset a Roth conversion from a traditional IRA with a donation of appreciated stock to a charity or DAF.
Of course, there are many more charity donation ideas, like Qualified Charitable Distributions (QCD) from an IRA, or ‘bunching’, and using charitable contributions to maximize deductions in a pass-through business, but let’s focus on two of these good ideas.
The Charitable Swap: Have Your Cake and Eat It (Too). This is a relatively easy option, often making use of a Donor Advised Fund. James Carpenter, Vice President and Charitable Planning Consultant with Fidelity Charitable, describes DAFs this way, “DAFs are one of the easiest and most tax-advantageous ways to give to charity. They allow donors to time their contributions for the maximum tax deduction, and also give them the opportunity to donate appreciated complex assets with the potential for tax-free growth, creating additional funds for charity.”
To make use of this option, the donor makes a gift of an appreciated stock that they’ve held more than one year to a charity or DAF, and then buy it back, maybe in a Roth IRA. Why? The donor would get a full charitable deduction this year, skirting possible Pease limitations imposed in a new administration, which would limit itemized deductions, and avoid the capital gain tax, which may go up in a new regime.
For example, suppose you owned 100 shares of TSLA (Tesla), which you bought on July 20, 2018 for about $62.72 a share ($6,272). It’s worth about $439.67 a share at the close on 10/16/2020, or $43,967. You have a significant ($37,695) capital gain. If you sell the stock (harvest the gain), you pay somewhere up to about $8,971 of federal taxes, plus state taxes (as high as 13.3% in California). If you donate the stock to a charity or DAF, you get an ordinary income deduction for up to 37% on federal (presuming you have enough other itemized deductions), plus possibly state deductions in some states (approximately 14 states). Thus, making the donation saves you up to $8,971 of federal capital gains tax (plus state income tax) and up to $13,947 of ordinary income tax due to the charitable deduction, for a total of $22,818 of federal tax savings (plus state taxes). If capital gains go to the ordinary rate (like if you make over $400,000 under a proposed plan), and if itemized deductions are limited, the savings is much more.
But wait, you say, I like TSLA. Cool, buy it back in some other account, perhaps a Roth IRA. In a Roth, there is no tax on qualified distributions. In addition, in a Roth IRA there is no basis issue. That means if you bought TSLA back in a taxable account at $43,767, and on the date of your death it was worth $100,000, if the law at the time of your death was carryover basis, your heirs would have to pay capital gains on the difference. If you bought the TSLA in a Roth, your heirs would be able to keep it in the Roth for 10 years and then take the entire balance tax-free.
Roth Charity Offset. You may have liked the previous example, but maybe you don’t have enough in a Roth to buy TSLA (or whatever other gainer you want to temper). Solution? Convert enough of your traditional IRA to a Roth to offset the deduction, and then buy the stock back there. If you converted $43,967 in the previous example, you’d accomplish the Roth conversion tax-free, still save the capital gains taxes, and have some money in a Roth to avoid future taxes and pass the money to heirs 10 years after your death tax-free. The growth in a Roth is financially superior to growth in a traditional IRA, or even in a taxable account. The traditional IRA has the friction of the Required Minimum Distribution (RMD), which is taxable, and has the new SECURE Act requirement that most non-spouse heirs take distributions (and pay taxes) over 10 years. Taxable accounts have the friction of capital gains taxes, with the possibility of higher capital gain rates and carryover basis.
Bottom Line: Weird high market valuations in some places and uncertain future tax laws are presenting some unique challenges. If you have any charitable inclination, 2020 could be a great year to do charitable swaps and possibly Roth investments, including Roth conversions to offset contributions. If you are uncertain about the best vehicle, you can donate to a charity directly or by using a Donor Advised Fund (DAF). A DAF is a charitable vehicle that lets you deduct the contribution now and allocate the future distributions to the charities of your choice. A DAF is one of the easiest ways to maximize a deduction now and make a donation to a specific charity later. Before year-end, look carefully at your big gains and your charitable wishes. Putting them together can pay off in the future. You do good for others while doing well for yourself.
As always, I’ll be happy to answer questions or cover other charitable ideas from some of my seminars. You can email me at llabrecque@sequoia-financial.com.