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Three Powerful Tax Strategies to Evaluate Now

By Tom Piro, CFP®, Enrolled Agent

With 2021 coming to a close, and major tax code changes being debated in Washington, now is an opportune time to evaluate three powerful tax strategies, which could be advantageous to you.   

As an enrolled agent (licensed by the IRS), I’ve spent a good amount of time studying the U.S. tax code, evaluating the potential changes currently being proposed in Washington, and devising long-term strategies to help our clients put together optimal, multi-year tax plans.   

I will be the first to admit that talking about things like the Alternative Minimum Tax doesn’t make me overly popular at cocktail parties.  But given that we are now in the final months of 2021, and major tax policy changes are being debated in Washington, it’s an opportune time to discuss a few strategies which could be advantageous for you.      

The goal of this article isn’t to cover all the details of a particular strategy.  The objective of the article is to provide visibility into some of the most impactful and relevant strategies, which could be advantageous to you given your personal situation, potential tax policy changes, and other macro-economic factors (such as low interest rates).    

An important item of note before we go into the details — as you all know, the U.S. tax code is complex.  For instance, implementing a strategy to optimize one area of your taxes (e.g.  converting a traditional IRA to a Roth IRA), can have an unintended consequence elsewhere in your overall financial picture (e.g.  increase in Medicare premiums).  So, it is important to have a comprehensive discussion with your Portfolio Counselor and accountant prior to executing a particular strategy.

With that in mind, below are three powerful strategies, which we believe are particularly timely and advantageous to evaluate now: 
1.  Active Roth IRA conversions
2.  Utilizing Charitable Remainder Trusts and Grantor Retained Annuity Trusts to maximize tax efficiency for families, and help charities
3.  Tax optimized strategies for charitable giving

Strategy #1:  Active Roth IRA Conversions

To start, let’s quickly define a Roth IRA conversion.  You’ll start by defining an amount of traditional IRA (pre-tax) dollars, paying ordinary income taxes on the amount, and converting it to a Roth IRA (post-tax).  The funds in the Roth IRA then grow tax free and are tax free upon distribution. 

There are several compelling reasons to evaluate Roth IRA conversions.  Including:

  • Take advantage of a potentially lower tax bracket today.
  • Take advantage of historically low marginal tax brackets.
  • Eliminate future Required Minimum Distributions (for yourself).
  • Develop a more balanced future tax liability.
  • Use a Roth IRA as a legacy planning vehicle.

There are many macro-economic factors which make now a good time to evaluate traditional (pre-tax) IRAs to Roth (post tax) IRAs:

  • Government Debt to GDP is near an all-time high. 
    • It was only higher in the late 1940s, as we emerged from the Great Depression and World War II.1
  • Marginal tax rates are historically low.2
    • For instance, a family who earned $300,000 (inflation adjusted) in 1950, would be in the 62% marginal income tax bracket.  Today, they are only in the 24% marginal tax bracket. 
  • Government entitlements (such as Medicare and social security) are forecasted to increase in the future.3 

Given these macro-economic forces, we believe there is a strong possibility marginal tax rates will increase.  A Roth IRA conversion makes sense as a way to protect yourself from these rising marginal tax rates.

You’ll want to talk to your Portfolio Counselor and accountant about the optimal amount to convert every year.  Additionally, there are additional strategies your Portfolio Counselor can evaluate with you, such as converting a larger portion of your traditional IRA after the stock market has declined in value.  

Strategy #2:  Take Advantage of Low Interest Rates and Trust Vehicles to Maximize Tax Efficiency for Families and Help Charities.

With potential changes to the tax code (e.g., reduction in the Estate Tax exemption amount, changes to how assets are handled and taxed within certain trusts), coupled with near historical low interest rates, we’ve had several conversations with clients about two tax advantaged trusts – as now is a particularly advantageous time to consider these trusts as a way to maximize tax efficiency for families and help charities.

Let’s start by defining the first tax vehicle, and why it is so advantageous to consider now:

A Charitable Remainder Trust (CRT) is a gift of cash or other property (such as appreciated stock or real estate) to an irrevocable trust. There are multiple benefits to the donor:

  • The donor receives an income stream from the trust for a term of years or for life.
  • With the gift of appreciated stock or property, the donor defers the capital gains which would have been generated by selling the property. 
  • The donor receives an immediate income tax charitable deduction when the CRT is funded based on the present value of the assets that will eventually go to the named charity.
  • The named charity receives the remaining trust assets at the end of the trust term.

There are a couple reasons why now is a good time to evaluate a CRT:

1. The stock market and real estate market have appreciated significantly in value in recent years.  

  • By gifting appreciated property to the CRT, you defer the recognition of capital gains over the life of the trust.  (Capital gains are recognized when funds are distributed from the trust).

2. Interest rates are near at historic lows.

  • As discussed earlier, one of the benefits of a CRT, is that the donor gets an immediate tax deduction for the present value of the assets that will eventually go to charity.
  • A key variable in determining the present value of the assets that go to charity, and the value of your immediate write off, is driven by interest rates (specifically, Section 7520 interest rates).
  • Without going into the nitty gritty of the calculation, the lower the interest rate, the greater the donor’s current write off.    
  • Therefore – with rates near historic lows – the tax write off a donor can receive is near all-time highs. 

The second tax vehicle that is advantageous to consider now is called a Grantor Retained Annuity Trust (“GRAT”).  This tax vehicle represents an opportunity for an individual to transfer appreciating assets to the next generation with little to no gift or estate tax consequences. Families can use GRATs to freeze the value of their estate while transferring any future appreciation to the next generation free of tax.

Now might be an opportune time for taxpayers who can benefit from a GRAT to consider forming one because:

  • Washington is currently debating major changes as to how assets are handled and taxed within a GRAT.
  • The estate tax exemption is $11.7 million per individual for 2021, but that figure is scheduled to revert to $5 million (as adjusted for inflation) as of January 1st, 2026.  This would make more estates potentially taxable and increase the need to remove assets from an estate.
  • GRATs work best when the Sec. 7520 interest rates are low, which are currently near historic lows.  

Let’s continue the discussion by defining how a GRAT works:

  • A GRAT is created when a grantor contributes assets with appreciation potential to a fixed-term, irrevocable trust. The grantor receives an annuity stream over the trust’s term. At the end of the term, the assets are distributed — typically to the grantor’s children.
  • Note that the grantor receives the right to an annuity stream and not the growth and income of the trust. If the trust does not generate sufficient income, the trustee must utilize the trust principal to make the annuity payment.
  • A taxable gift is calculated by subtracting the value of the grantor’s retained interest from the fair market value of the property transferred into the trust.
  • The IRS assumes that the trust assets will generate a return of at least the applicable Sec. 7520 rate in effect for the month the assets were transferred to the trust.
    • Any appreciation in excess of the Sec. 7520 rate passes to the beneficiaries free of gift tax.  This is the main benefit and a great way to gift to children.

For a grantor with a highly appreciated asset, who wants to efficiently give to children while being mindful that estate tax exemption amounts will likely reduce, now is a great time to evaluate a GRAT strategy. 

Strategy #3:  Tax Optimized Charitable Contributions

This is the time of year many of us consider giving gifts to our favorite charities.  There are several ways to give to charities.  We’ll quickly explore tax-optimized ways to give in 2021 and beyond.   

Writing a check to our favorite charity is a great way to potentially reduce your 2021 tax liability.  There can be additional opportunity to reduce your overall 2021 (or future year) tax bill to Uncle Sam.  One strategy is to gift highly appreciated stock instead of cash.  Remember, $100 of highly appreciated stock is just as valuable as $100 in cash to a recognized 501(c)(3) charity.  In giving $100 of appreciated stock, you don’t have to sell the appreciated stock (and owe capital gains tax and Net Investment Tax).  So, you potentially get a double tax benefit of:  1.  A charitable write off  2.  Avoidance of capital gains tax.    

It is important to note – in gifting appreciated stock, there are limitations as to how much you can deduct in one year.  Specifically, the write off for gifting capital gain properties is limited to 30% of your Adjusted Gross Income (AGI).  (Gifts beyond 30% of your AGI could be deductible in future tax years). 

Additionally, with the significant increase in standardized tax deductions (via 2017 Tax Cuts and Jobs Act), nearly 9 in 10 Americans do not itemize their tax returns.  Ordinarily, individuals who elect to take the standard deduction cannot claim a deduction for their charitable contributions.  The law now permits these individuals to claim a limited deduction on their 2021 federal income tax returns for cash contributions made to certain qualifying charitable organizations.

These individuals, including married individuals filing separate returns, can claim a deduction of up to $300 for cash contributions made to qualifying charities during 2021. The maximum deduction increased to $600 for married individuals filing joint returns.  However, this $600 deduction, is often far less than the value of a tax payer’s charitable gifts who utilize the standard deduction. 

If you take the standard deduction and want to maximize the tax value of your charitable contributions, you should evaluate opening and contributing to a Donor Advised Fund (DAF) & “bunching” contributions in 2021 or a future year.  Here is how the strategy works:

  • Open a DAF, which is a giving account established at a custodian (like Charles Schwab or Pershing). The DAF allows donors to make a charitable contribution, potentially receive a tax deduction and then make gifts to various charities from the DAF over time.  Donors can contribute to the fund as frequently as they like, and then recommend grants to their favorite charitable organizations whenever it makes sense for them.
  • In practice, bunching simply means that the donor “bunches multiple years of contributions” with the goal of creating one large charitable gift in a given tax year, and itemizing your tax return, instead of making numerous smaller contributions and taking the standard deduction (significantly reducing the tax benefit of the charitable gift).  
  • For example, every third year a donor contributes to their DAF with an amount equal to the total needed for three years. In that year, the donor itemizes their deductions (instead of a standard deduction) when filing their tax return.  In the next two years, the donor makes their grants from the DAF and claims the standard deduction on the tax returns for those years.

We hope you can see the value and tax efficiency in the above strategies.  Talk to your Portfolio Counselor and accountant to have a thoughtful discussion around all of the tax considerations, limitations, and develop calculations and tax scenarios for you – to help you make the best decision.

1 Tradingeconomics.com & U.S. Bureau of Public Debt, as of 12/31/2020
2 Source:  Tax-Brackets.org;  Inflation Calculator, as of 12/31/2020
3 Source:  Tax-Brackets.org;  Inflation Calculator, as of 12/31/2020

Tom Piro, CFP®, Enrolled Agent

Tom is a Portfolio Counselor for OPCM with over 15 years of experience in the financial services industry. Tom built his career working with complex clients at a regional wealth management firm and through management consulting roles at PricewaterhouseCoopers and Lattice Engines. He brings a broad skill set and passion for financial planning and investment management to our clients. Tom is an Enrolled Agent (EA), a tax professional who has passed a three-part IRS test covering all aspects of taxation. The EA is the premier tax accreditation recognized by the IRS. Tom earned his BS in Business Administration, Summa Cum Laude from Saint Mary’s College. Additionally, he is a CERTIFIED FINANCIAL PLANNER™ practitioner.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.