We are closing out the month of April, which is remembered primarily for rain showers and income taxes. April has another important designation; one that is especially meaningful to us. April is Financial Literacy Month, timed perfectly to coincide with American’s annual obligation to pony up for the privilege of living in a free society, we are told. Most of us would feel better about paying taxes if we had more confidence that a large percentage of our taxes weren’t wasted on such noteworthy projects as recording shrimp on a treadmill.
Government waste is a topic for another time, as today we will look at minimizing taxes under the Tax Cut and Jobs Act that took effect this year on January 1. Although the framers of the law seem to have dropped the assertion that tax simplification was a primary objective, for many people it did turn out that way. For many Americans, large increases in the Standard Deduction relegated itemizing deductions to the trash heap of annual paperwork.
Under the new rules, taxpayers using the Standard Deduction have very few legal techniques with which to reduce their annual tax burden. The simplest way to pay less taxes is to earn less reportable income. That is hardly palatable for most people, but there are some exceptions. One way to reduce taxable income is to utilize tax-exempt municipal bonds to replace taxable CDs, Money Markets, and various taxable bonds. This is effective for some people, but there are a couple drawbacks. Tax-exempt bonds generally carry a lower interest rate than do taxable bonds. Also, tax-free interest must be added back in with other income to compute Modified Adjusted Gross Income, which is used to determine the taxable portion of Social Security benefits and the Alternative Minimum Tax, or AMT.
For one subset of older Americans there is a technique called the Qualified Charitable Distribution, or QCD. In order to qualify, a taxpayer must be age 70-1/2 or older and subject to Required Minimum Distributions (RMDs) from a tax-deferred Retirement Account. For anyone who meets those criteria, and who is also a charitable donor (to an IRS-approved charity), the QCD can create a true and legal tax savings by reducing reportable income.
The QCD can be used for all or any part of an RMD, and is relatively simple to execute. The IRA owner informs the custodian of the IRA that the desired amount of the RMD be paid by the custodian directly to the charity. Any remaining portion of the RMD is then paid to the IRA owner as usual.
The net effect of the QCD is to reduce the 1099 received at year-end by the amount of the QCD. Since the QCD is not reportable to the IRA owner, it is not taxed as income. This has the same net effect as the former charitable deduction. For people who no longer itemize, the QCD creates a de-facto tax deduction.
We may not be done yet, either. In some cases, the use of a QCD may reduce the donor’s Gross Income by enough to put the taxpayer’s Taxable Income in a lower bracket. This would further lessen the donor’s tax bill. Stretching the case further, some taxpayers may actually reduce their Taxable Income enough that all their capital gains for the year become tax-free, as taxpayers in the two lowest tax brackets do not have to pay taxes on their Capital Gains.
Financial planning is not solely for the Uber-Wealthy. Understanding the concepts of investing, taxation, insurance, retirement, and estate planning takes years of training and study. Knowing when and where to turn for help makes these concepts available to the public. Learning what to ask and whom to ask is our contribution to Financial Literacy Month.
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