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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and given that the end of the year is right around the corner, I'll be dedicating the rest of our 2020 content to year-end tax planning strategies. Today, I'm talking about how you can combine a popular tax planning strategy with charitable giving. In fact, this strategy can help wipe out this year's tax bill, reduce future tax bills, and also support some good causes along the way. The best
the best part is there's no minimum amount of net worth required to take action here. So if you want to make a smart tax move while also supporting a good cause, today's episode is for you. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 89.
Okay, first, before we dive in, given that we've spent the entire month of September talking about investing in stocks and learning about the different drivers of returns, I wanted to highlight what's happened in the last month just in case you missed it. And I'll preface this by saying that I'm not suggesting or predicting that this trend will continue. In fact, by the time this episode airs, the trend could have already reversed. That's how quickly these things can change.
But, given that small cap value stocks have had such a rough decade, as I pointed out during our series on stocks in September, many of us are keeping a really close eye on that trend changing. It can't last forever. At some point, this trend is going to turn around.
At least in the very short term, we've seen these things change pretty dramatically. And so here are the index returns for the last 30 days from October 9th to November 11th. So these are the index returns. The Russell 1000 growth in the last 30 days was up just under 1%, 0.9%. The S&P 500 was up 2.8%.
Russell 1000 value index was up 4.75% and the MSCI US small cap value index was up 7.1%. So again, Russell 1000 growth up 0.9%, MSCI US small cap value up 7.1%. So in other words, in the last 30 days, small cap value stocks here in the United States have
have outperformed growth stocks by 6%. A MarketWatch article, which I'll link to in the show notes, pointed out that you would have to go back to September of 2008, 12 years ago, to reach the current level of underperformance of growth versus value.
So the big question is, you know, what do we do with this information? And my answer is really not much other than to reinforce how quickly these things can change and how important it is to have a sound, robust, diversified portfolio that's rooted in academic research. So with that out of the way, let's get into today's topic and into some tax planning. Specifically, I'm going to be talking about combining a popular year-end tax planning strategy with charitable giving. And
And the popular year-end tax planning strategy, which I've talked about at length here on the podcast, is known as a Roth conversion. A Roth conversion, just as a reminder, is the process of transferring money from your traditional IRA or traditional 401k account to a Roth IRA.
And as you might know, when you move money out of a traditional IRA or 401k, which includes transferring it to a Roth IRA, this is a taxable event. You're taxed at ordinary income tax rates, just as if you earn that money in the workforce. And given that it's a taxable event, you have to really navigate Roth conversions carefully.
In its most basic form, there are more situations, but just in a basic form, there are two typical situations where you'll see Roth conversions recommended. The first is a person under the age of 72 retires from
loses their income and drops into a low tax bracket. This gives them an opportunity to start getting money out of their traditional retirement accounts, their traditional IRAs, their traditional 401ks, gives them this opportunity to start getting out of those accounts before required minimum distributions kick in when they turn 70.
We call the years between your retirement date and the year you turn 72. We call those your gap years and your gap years provide some amazing tax planning opportunities and Roth conversions are one of those opportunities.
The second situation you'll often see Roth conversions recommended is a person in a 24% tax bracket or lower. Their income is relatively unchanged, but they still have room left in their existing tax bracket to add more income without jumping into the next higher tax bracket or tier.
Just know that a careful analysis needs to be done when you do this to determine if filling up an existing tax bracket actually makes sense based on estimated future tax bills. So just be careful there, but that's another common strategy is filling up an existing tax bracket.
In general, Roth conversions, if done correctly, they help to lower your future tax bill. You're strategically paying taxes today at a lower rate than what you'll be forced to pay in the future via RMDs and when social security kicks in and maybe pensions and other income, all those things kind of collide at age 72. And as I've said before, you can be in a much higher tax bracket at age 72 than as a working professional.
So doing these correctly, doing Roth conversions can help lower that future tax bill. But here's the kicker. What if you could do a Roth conversion, lower that future tax bill and avoid paying the current year taxes that you would normally expect to pay when pursuing this strategy?
Yes, this is possible and no, it's not too good to be true. However, there are two important caveats to know about before I share a real life example of how this can work. Number one, like any Roth conversion strategy, you do need to have cash or investments available outside of your retirement accounts to help pay that tax bill. So if you don't have money outside of those retirement accounts, it can be pretty tricky to do Roth conversions.
Number two, you need to be charitably inclined to pursue the strategy that I'm going to talk about here shortly. You don't need to want to give away half your money to charity or anything like that, but you have to have some intention of charitable giving between now and the end of your life.
So here's an example of how this works. This is technically a hypothetical example, but based on a real life potential situation, but it's still hypothetical if you know what I mean here. So let's just call this hypothetical married couple, Tom and Linda. Tom and Linda are retired, living on the beach here in sunny San Diego, and they're worried about how much they're going to pay the IRS in retirement and through the end of their life.
Quick side note here, if you've never projected your estimated lifetime tax bill from retirement until the end of your life, I highly recommend that you go through this exercise. And don't be surprised if you find out that you'll be paying the IRS seven figures or more even though you aren't working anymore.
The good news here is there's a number of legal things that you can do to dramatically reduce that number. But I highly recommend as a starting point, estimating that lifetime tax bill in retirement through the end of life. It's a really, really important exercise to go through. Okay. So going back to our example of Tom and Linda, again, they're retired living on the beach in San Diego, and they're worried about how much they're going to pay the IRS in retirement. In 2020,
They're projected to have gross income of $87,000. But since they have $27,000 in deductions, their taxable income this year is actually closer to $60,000. This puts their effective tax rate at 6.8% and creates a tax bill in 2020 of about $4,000.
Given that they're in such a low tax bracket, they're naturally interested in a Roth conversion before the end of the year. And with some expert help, they landed on the recommendation of converting $75,000 from their traditional IRA account to a Roth IRA account.
And a Roth conversion this year of $75,000 is going to cause their effective tax rate to more than double to 14.4%. So instead of owing about $4,000 this year, if they do this conversion, they're now going to be projected to owe the IRS about $19,500. And they, of course, like you and me, they don't like this spike in taxes and they don't want to pay the IRS an additional $15,000.
Fortunately, Tom and Linda are generous people and they like the idea of giving money to charity, just not today. Maybe in 10 years or maybe even at the end of their life. They're not sure on the timing, but they do like the idea of giving money to charity at some point.
Given that, here's what they can do. They can do the Roth conversion, the $75,000 Roth conversion, and at the same time or in the same year, they can contribute $75,000 to a donor-advised fund.
By contributing $75,000, the same amount as the Roth conversion, by contributing that to a donor advised fund as well, they're able to offset the taxes from the Roth conversion and they're now back to an effective tax rate of 6.8%.
So again, $75,000 Roth conversion creates that tax bill. They take $75,000 from somewhere else, contribute it to a donor advised fund, and it offsets the taxes from the Roth conversion. Now, the great thing about a donor advised fund and why it's so fitting here is that they get the tax benefit of that 70 at full $75,000 charitable contribution. They get the full tax benefit today.
but they don't actually have to make any donations to charities right away. They can invest the money, grow it, and give it away down the road, or maybe they decide to keep that money in cash inside the donor advised fund and just give a little away each year as they feel like it. They have total flexibility around their lifetime future charitable giving plans, but they get to use the entire tax deduction today to offset that Roth conversion.
At my firm, we use Fidelity Charitable's donor advised fund and two months ago, Fidelity Charitable waived all account minimums in an attempt to make donor advised funds more accessible to the average American household who donates about $2,600 annually.
So while you might not be in Tom and Linda's shoes and have the ability to put $75,000 into a donor advised fund, you can still pursue this strategy. Maybe you just want to fill up your existing tax bracket through, uh, you know, let's say a $10,000 Roth conversion this year. And maybe you don't want to part with a $10,000 donor advised fund contribution. That's a lot of money to just part with for, you know, an earmark for charitable giving, even if it is in the future.
that's not a problem. You could contribute $2,000 or $5,000 to a donor advised fund. Just know that the more you contribute, the more you'll offset that Roth conversion tax bill.
Lastly, if you want to maximize the benefits of a donor advised fund, consider making your contribution with appreciated stocks or securities. In other words, stocks or bonds or other securities that have gone up in price and have a tax consequence if you sell them. So those are appreciated securities. For instance, maybe you got lucky and you bought just randomly, you bought $3,000 worth of Tesla stock in January of this year, and now it's worth $12,000. What's the point?
Well, if you sold that stock today, you would pay taxes on that $9,000 gain. You don't actually get to walk away with $12,000. Instead of doing that, instead of selling it and paying taxes on that gain, you could actually contribute the full $12,000 of that appreciated stock directly into a donor advised fund
offset that Roth conversion tax bill, and you get to avoid paying the capital gains tax on that appreciated stocks. You actually get to donate more money than if you sold it, paid the taxes, and then donated it. So by doing this, by donating appreciated securities into the donor advised fund, it's a huge win. It's a win, win, win for everybody.
In summary, consider pairing your year-end Roth conversions with a donor-advised fund contribution to offset the tax bill. Even better, contribute appreciated securities to the donor-advised fund if you want to maximize that tax benefit.
There's just one thing here that I don't want you to do. And that is to follow this strategy. If you're not already charitably inclined, in other words, don't give money to charity. Don't put money in a donor advised fund just to get a tax break here. That would not be a rational approach.
Remember, you can process annual Roth conversions without pairing them with charitable giving. And if you do them correctly on an annual basis, this is still a wise long-term tax planning strategy. So you don't have to be charitably inclined to use Roth conversions. This is just one unique way to pair these things together to really maximize the tax benefits and achieve your long-term goals.
For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 89. Thanks so much for listening today, and I'll see you back here in two weeks. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.