Now that the 2016 income tax filing season is behind us, we can focus on 2017 tax planning. Although the stock market is down about 3% from record highs, there are a lot of investors with significant unrealized capital gains in nonretirement investment accounts. The dilemma for these individuals is how to sell their appreciated securities without paying a lot of income tax.
Capital Gains Tax
Selling securities in a nonretirement investment account can subject gains to a tax rate as high as 23.8% for securities held longer than a year (long-term) and 43.4% for securities held one year or less (short-term). The foregoing rates include a net investment income tax of 3.8% for higher levels of income. Capital gains are also subject to state income tax which varies by state and can be as high as 13.3 percent in California.
In a best-case scenario, forgetting about state income tax, your net long-term capital gains will be taxed at a long-term capital gains tax rate of 0% if your marginal tax rate is 15% or less. The rate jumps to 15% for those in a marginal tax rate of 25% to 35%. It increases to 20% if your marginal tax rate is 39.6%.
Donor Advised Funds to the Rescue
Assuming that you’re charitably inclined, there’s a strategy you can use to eliminate the tax that you would otherwise pay if you sell highly appreciated securities and obtain an income tax deduction to boot. It’s called a donor advised fund, or DAF.
A donor advised fund allows you to make a charitable contribution and receive an immediate tax deduction without having funds simultaneously disbursed to charitable organizations. They remain in an investment account in the DAF until you decide to make grants from your DAF to designated charities.
Donor advised funds are a popular philanthropic vehicle. Per the National Philanthropic Trust’s 2016 Donor-Advised Fund Report, there are nearly 270,000 DAFs that received contributions totaling $22.2 billion with charitable assets totaling $78.6 billion making grants totaling $14.5 billion.
Cash Donation to Donor Advised Fund
You can write a check to a donor advised fund and receive an immediate income tax deduction. Let’s suppose that you’re in a 33% income tax bracket and you’re also subject to the net investment income tax of 3.8%. You want to make contributions to several different charities totaling $20,000 a year for the next three years, or a total of $60,000. You’re planning on selling two exchange traded funds (ETFs) with a total value of $66,000 for which you paid $35,000 six years ago to provide the funds for your donations.
Ignoring state income taxes, you will incur income tax liability of $5,828 on the sale of your exchange traded funds. This includes a long-term capital gains tax rate of 15% plus the net investment income tax of 3.8%, or a total of 18.8% of your gain of $31,000. You will have net after-tax proceeds of $60,172 ($66,000 – $5,828) to use to make your desired contributions.
When you make your contributions, you will reduce your federal income tax liability by $6,600 a year ($20,000 x 33%), or a total of $19,800 over the three years. Your net tax savings is $13,972 ($19,800 – $5,828).
Increase Your Tax Savings
Instead of selling your exchange traded funds and donating the after-tax proceeds to your desired charitable organizations over three years, you can donate your ETFs to a donor advised fund. In addition to avoiding income tax on the sale, you will receive an income tax deduction for the value of your ETFs ($66,000).
Your ETF donation will result in income tax savings of $21,780 ($66,000 x 33%). This is $7,808 of additional tax savings ($21,780 – $13,972) achieved by donating your ETFs to a DAF vs. selling them and donating the after-tax proceeds. When your ETFs are sold by your DAF, neither your DAF nor you will incur any income tax liability.
As an added bonus, you realize 100% of the tax savings in one year vs. spreading it out over three years. This will be the case regardless of when you make grants to charitable organizations from your DAF. The only limitation on your charitable deduction is that the total of all of your gifts of appreciated securities and other assets to your DAF is limited to 30% of adjusted gross income, with any unused deduction carried over to future years.
Leverage Your Donations
Whether you donate cash or appreciated securities to a DAF, you can potentially make larger grants to charities than the value of your contribution. If the DAF is invested in non-cash assets and they increase in value, those assets can be sold and larger grants can be made to charities.
Let’s suppose that you donate ETFs with a value of $66,000 to a DAF and the ETFs increase in value by 10% so that they’re worth $72,600 a year from now. Assuming that your DAF sells your ETFs and the funds aren’t reinvested, you will be able to make grants totaling $72,600, or $6,600 greater than the value of your donation a year ago.
Reduce Downside Risk
What happens if the value of the ETFs in your DAF decreases by 10%, going from $66,000 to $60,000 a year after your donation? The first thing to keep in mind is that you realized tax savings of $21,780 in the example when you contributed your ETFs to your DAF. The subsequent value of your ETFs doesn’t affect the amount of your tax deduction.
Second, if your DAF sells the ETFs after the value has dropped to $60,000, this is the amount of after-tax proceeds that you would have donated to charitable organizations had you sold your ETFs a year ago instead of donating them to a DAF. The only downside with the donor advised fund route are administrative fees and potential investment management fees that you might incur anyway.
Avoid Capital Gains Tax and Increase Tax Savings
If you have appreciated securities that you’re considering selling and you’re charitably inclined, a donor advised fund (DAF) makes sense. There are four distinct benefits that make this strategy attractive:
- Avoid capital gains tax on securities sales used for donations
- Increased charitable contribution deduction and tax savings
- Timing of grants to charitable organizations independent of donation to DAF
- Potentially larger donations to charities
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.