“Generally, a donor advised fund (DAF) is a separately identified fund or account that is maintained and operated by a section 501(c)(3) organization, which is called a sponsoring organization. Each account is composed of contributions made by individual donors. Once the donor makes the contribution the organization has legal control over it. However, the donor, or donor’s representative, retains advisory privileges with respect to the distribution of funds and the investment assets in the account. Donors take a tax deduction for all contributions at the time they are made, even though the money may not be dispersed to a charity until much later. Because you receive the tax benefit immediately, your contribution is irrevocable, which means your assets cannot be returned to you for any reason.”
How to focus on proactive tax planning as a high earning W2 employee
Presently, a lot of folks aim to act on tax planning opportunities once the prior calendar year is complete, and they are working with their tax professional to file their tax return.
However, at this point, there is not too much you can do to reduce your tax liability if you are a W2 employee – an ‘it is what it is’ type of moment. If you are a business, there are potentially a few more chances here, but again, more fruitful opportunities are typically present throughout the calendar year.
In any case, this is a perfect example of reactive tax planning – strategies are assessed after the fact, rather than leading up to it. In addition, the decision to simply reduce taxes in this one singular year may not make sense in the long run.
This is where the role of proactive tax planning comes in – the art of working to understand potential tax liabilities well in advance, then proactively identifying and implementing strategies to minimize taxes, or defer taxes with the hopes of withdrawing at a lower tax rate than you’d pay today.
In today’s blog, we will walk through a few planning opportunities I typically assist clients with to efficiently manage their tax situation:
- Maximizing 401k & 403b plan contributions (Pre-tax or ROTH)
One of the options almost everyone can take advantage of is to fully utilize contributions to your employer-sponsored retirement plan – i.e. 403b, 401k etc. In 2024, you can put up to $24,500 (if under age 50) or $32,500 ($24,500 + $8,000 catch up) + $35,750 if between ages 60-63, into these types of plans. Most offer contributions on a pre-tax or ROTH basis.
Pre-tax = taxes on the contributions are deferred today (can reduce taxable income today) & withdrawals are 100% taxable at your ordinary income rate
ROTH = pay taxes today (growth & withdrawals are 100% tax free after 5 years & age 59.5 is reached)
As a note whether over or under age 50, the maximum amount you can individually contribute between pre-tax and ROTH are the figures above – you cannot contribute $24,500 into ROTH & $24,500 in pre-tax, as an example. Furthermore, these figures do not count your employer match; you can individually contribute $24,500 and still receive your employer match – if under age 50.
Now, many folks have varying opinions on the level of each contribution type – i.e. all ROTH, all pre-tax, or a balance of both. In my experience, this truly depends on your individual tax situation now, and your outlook for future income growth.
As a general guideline, you could consider all ROTH when in lower-brackets, mix of both when in the moderate brackets, and 100% pre-tax once you reach some of the highest tax brackets, as these are most likely your highest earnings years.
Even if you plan to retire prior to 59.5, retirements vehicles are a powerful place to hold funds and have them grow tax deferred and in some cases come out tax-free. Remember, whether you retire at 55 or 65, the monies you put away need to be positioned to last until the end of your life, so if you live to age 90, and you retire at 65, this could be another 25 years of growth while taking withdrawals!
- Asset Location (Tax Efficient Growth & Withdrawals)
Asset location nicely ties into the above-mentioned section, as the goal here is to create choice and flexibility surrounding your investment and tax planning – and in some cases this feeds into your estate / wealth transfer planning.
Utilizing the power of asset location looks a bit like this:
• ROTH Accounts: holds the assets with the highest growth potential
- Aggressive investment allocation = 80% stock / equity or above
- 100% tax free upon withdrawal as long as the account has been open for 5 years and over age 59 ½
• Pre-tax Account: holds the assets that are the least tax efficient, have modern growth potential
- REITs, bond funds, high dividend pay mutual funds or stocks, etc.
- Withdrawals – 100% taxable at your income tax rate
• Taxable Investment Account: holds the most tax efficient assets
- Individual stocks, low dividends stocks / funds, ETFs
- Assets held longer than 1 year then sold are subject to capital gains rates 15% for most people at the federal level (plus state) – could do some planning to pay 0% on the federal level
- Assets held less than 1 year then sold are subject to income tax rates
If done properly, this type of planning could allow an individual to minimize their lifetime tax bill and increase portfolio return potential over their lifetime.
In conjunction with the section above, asset location is a marathon, not a sprint, so this level of tax diversification does not need to be accomplished overnight, nor should it be. You should be taking your time as you set this up to properly coordinate with your individual income, tax, and lifestyle circumstances.
- Donor-Advised Fund (Charitable Giving)
In my experience, people who are generous when they have little to give, often become even more generous as they build wealth. It is no secret that giving charitably – both in monetary form & one’s time – can make a huge impact on those you are helping, but also you as the giver.
With this in mind, when clients give charitably, they are usually writing a check each year to their favorite organization, church, synagogue, etc. – here is where I usually bring up the strategy of using a donor-advised fund (DAF).
Instead of simply writing a check each year utilizing a DAF can allow you to make a more impactful gift overtime, and receive tax benefits.
Here is how it works:
• Donor gifts cash, appreciated stock, ETF, mutual fund, etc. into the DAF
- The donor receives a tax deduction against their income that could be as high as 60% of adjusted gross income (AGI)
- If the entire donation cannot be deduction in year 1, it can be rolled over for up to 5 years
• Once in the DAF, donors can choose from a range of investment options to grow these monies until they are ready to recommend a grant to a charity
• The donor can make grants to one or several 501(c)(3) organizations along the way
Where you can take this a step further is if you do have appreciate stock in a taxable account, you could consider giving the appreciate stock to the DAF and receive the tax deduction today – doing so also allows you to not pay the capital gains tax the appreciated shares, as you would be required to if you sold the shares personally.
Once the contribution to the DAF is complete, you could use the cash you were going to give to the DAF or charity directly and repurchase the shares in the open market and receive a new cost basis.
When used properly, this can be a very powerful planning tool!
- Qualified Charitable Distributions (QCD)
Another way to optimize your charitable giving and potentially minimize taxes in the process is to consider a QCD with your IRA (pre-tax) monies.
You become eligible for a QCD when you attain age 70 ½ - under current laws you and your spouse can both contribute up to $111,000 a year in QCD’s. So, for a married couple, this could be up to a potential $222,000.
So, when and how does this come into relevance?
Most folks consider this strategy when they reach their Required Minimum Distribution age (RMD) - age 73 if born prior to 1959 & age 75 if born 1960 or later under current laws -.
For example, let’s say that a person is living comfortably on their non-IRA assets and Social Security (or a pension), meaning they may not need their RMD for income purposes, and taking it could mean paying more in taxes. Let’s assume the RMD is $50k for the year.
So, instead of taking the RMD for income purposes, they could consider utilizing the QCD strategy to gift their RMD of $50,000 directly to the charity of their choice. In doing so, the amount allocated to the QCD satisfies the person’s RMD for the year, and removes it from income, meaning no tax liability is owed. Even more, the individual does not need to be itemizing deductions (vs. taking the standard deduction) to take advantage of this tax break
Pretty cool right? In addition, some financial institutions actually allow the account holder to have check writing ability from their IRA, which can simplify this process. The individual does just need to make sure they file the correct forms with their tax return to properly record this transaction.
This can be a very impactful way to make a large gift to a charity of your choice and reduce your taxable income in the process.
As I close out this week’s blog, I hope this was helpful, and as always, reach out with any questions or if you’d like to chat further. Be well!
*Generally, a donor advised fund (DAF) is a separately identified fund or account that is maintained and operated by a section 501(c)(3) organization, which is called a sponsoring organization. Each account is composed of contributions made by individual donors. Once the donor makes the contribution the organization has legal control over it. However, the donor, or donor’s representative, retains advisory privileges with respect to the distribution of funds and the investment assets in the account. Donors take a tax deduction for all contributions at the time they are made, even though the money may not be dispersed to a charity until much later. Because you receive the tax benefit immediately, your contribution is irrevocable, which means your assets cannot be returned to you for any reason.
**Tax/accounting services are separate from and not offered through Commonwealth Financial Network®.