The potential for higher tax rates, coupled with markets near or at all-time highs, are keeping investors and their advisers on alert. While investors save to cover future spending, their advisers are helping to evaluate wealth-transfer opportunities. A tailored strategy can integrate gifts to both individuals and charity as part of a lifetime or legacy plan.
Even those who are saving for retirement may benefit from taking advantage of lower tax rates and getting in front of potential tax changes on the horizon.
With no shortage of available charitable solutions, evaluating a plan for assets earmarked for spending as well as charity is beneficial. Identifying appropriate alternatives to meet both goals while managing taxes can be challenging. An effective strategy will consider the tax attributes of both currently taxable and tax-deferred accounts and pair solutions to deliver potential tax savings and other advantages.
Planning for Taxable Assets
Long-term investors in today’s markets may find themselves holding securities that have appreciated substantially. Effectively managing the tax consequences of those assets requires an understanding of potential capital gains taxes when selling or transferring appreciated assets. If you transferred highly appreciated shares to a loved one during your lifetime, the recipient generally could carry over the cost basis of the appreciated securities and only recognize the gain when securities are sold. If the recipient is an adult child or other individual in a low tax bracket, a gift of appreciated securities you’ve held over one year from time of purchase can allow the recipient to be taxed at a lower capital gains rate.
For example, if an investor who would be taxed at a 20% capital gains rate transfers the appreciated asset to a child in a tax bracket where their capital gains are taxed at a 0% or 15% rate, the family can benefit from lower taxes. Recipients in states where state capital gains rates are lower or non-existent (such as Florida or Texas) may also end up paying less tax.
Passing down appreciated assets after death can offer an even better tax savings for your family. Those not making lifetime transfers to individuals, or who have no reason to sell appreciated assets for diversification or to adjust their asset allocation — provided they are willing to accept the investment risk — may want to consider holding those appreciated securities. At death, the assets allow recipients to receive a step-up in cost basis. The step-up allows the recipient to reset the cost basis of an appreciated asset to fair market value established at death of the account owner.
Conversely, any assets held at a loss are better if sold during the life of the account owner, as they can be used to offset gains from any appreciated assets also sold during the life of an account owner (and spouse if held as a joint account). If held until death, assets held at a loss could result in step-down in basis, meaning the new owner would take the asset with a new lower basis — something that’s not desirable when you’re trying to limit capital gains taxes.
Another route for limiting capital gains taxes is to consider a charitable donation. If appreciated securities are gifted to charity, they can then be sold by the charity without the donor incurring any capital gains taxes. Making a charitable gift of low-cost-basis securities, or where the cost is hard to value (such as shares of stock acquired under a stock dividend reinvestment program), or where a cost basis is unavailable can save time, costs and taxes. The recipient can be an operating charity, a donor advised fund or a private foundation.
Planning for Tax-Deferred Assets
Unlike taxable asset portfolios, retirement assets, such as traditional IRAs, 401(k)s and other qualified retirement plan assets, are generally subject to ordinary income taxes when distributed (except for after-tax contributions). Unlike assets held in taxable accounts, lifetime transfers to individuals in lower income tax brackets are not possible, and the retirement assets won’t receive a step-up in cost basis at death. There are a few maneuvers to circumvent or delay taxes.
Normally, IRAs cannot be transferred without a tax liability when transferred to charity during life. However, a qualified charitable distribution (QCD) allows for non-taxable transfers of IRA assets to a public charity during the account owner’s lifetime. When planning for distributions during their lifetime years, those who are 70½ or older and also want to make charitable gifts can use a traditional IRA to take advantage of QCD (also referred to as a Charitable IRA rollover) to donate IRA funds to charities and, when applicable, also meet their annual required minimum distributions.
QCDs are direct payments to public charities allowing traditional IRA account owners (and inherited IRA owners and certain SEP and SIMPLE plans — but not other retirement plan account owners) to make a direct transfer to a public charity without having to be taxed on the distributions of up to $100,000 of the annually. The amount distributed to charity also qualifies for the annual required minimum distribution now effective at age 72, (as mandated under the SECURE Act). To note, QCDs are still available to taxpayers beginning at age 70½, regardless of the RMD beginning date, but the tax benefits of a QCD are limited if a taxpayer makes contributions to their IRA.
Finally, for those whose charitable giving plans include donor-advised funds and charitable foundations, there are a couple of things to keep in mind. Though certain tax-deferred assets, such as IRAs and other retirement plan assets, cannot be donated to either a donor advised fund or private foundations free of taxes during life, those entities can be named as beneficiaries from a retirement plan at death. In fact, using non-Roth retirement funds as a source for charitable bequests is a tax-effective estate planning strategy.
When investors review both using taxable and retirement plan assets to meet their goals, they can begin to identify favorable solutions for managing their taxes. The importance of knowing how to position individual assets now and in the future will enable them to make better decisions for both taxable and tax-deferred assets to improve results.
The views expressed within this article are those of the author only and not those of BNY Mellon or any of its subsidiaries or affiliates. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.
This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.
As a Senior Wealth Strategist with BNY Mellon Wealth Management, Kathleen Stewart works closely with wealthy families and their advisers to provide comprehensive wealth planning services. Kathleen focuses on complex financial and estate planning issues impacting wealthy families, key corporate executives and business owners.
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