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Retirement Weekly: Inheritance, estate planning and charitable giving: 4 strategies to reduce taxes now

Working in the Washington, D.C., area, no matter who’s in the White House, I’m often thrust into conversations about tax policy. My clients tend to be more aware of various political issues and they’re particularly interested in tax law changes and how those changes affect wealth.

Historically those conversations have been more academic and almost theoretical. But in recent years, they’ve really changed as we’ve seen a psychological shift in how clients think about taxes, charitable giving, estate planning and inheritance. Once more hesitant to plan ahead, clients in today’s environment are much more proactive and willing to take action in the near term rather than waiting and risking having to pay higher taxes down the line.

Take, for example, recent Build Back Better bill conversations. With their negotiations and uncertainty, an overwhelming number of clients are proactively asking us to help plan for the financial impacts that tax changes could bring. These tax-sensitive investment strategies discussed with clients are worthwhile no matter when and if changes take effect.

Here are four strategies we discuss with clients:

Offsetting capital gains

Capital gains affect almost everyone with assets. Simply put, capital gains are the profit you make from selling an asset that has appreciated in value since you first acquired it. Not surprisingly, those gains are taxed – though at lower rates than ordinary income if the asset is held for more than a year. Conversely, losses you incur on your assets can help reduce tax liability. This is one area where we advise clients to strategically harvest tax losses to offset gains.

It’s common to see clients sell one stock that has depreciated simultaneously along with another stock that’s worth more than what they paid for it because the loss on one would reduce tax liability on the other. Clients often do this exercise at the end of each year, but today, recognizing that tax on capital gains may increase, an increasing number of clients are proactively employing this strategy throughout the year. This allows them to take advantage of market volatility during times of decline.

Evaluating Roth conversions

Many clients used to assume that when they retire, they’ll be in a lower tax bracket, thus giving them an advantage when they start making withdrawals from their retirement accounts. But wealthy clients have Social Security benefits, and sometimes a pension or other retirement income sources, they may also be generating income from their portfolio by way of dividends and interest payments. Combined, these sources of income in retirement often match their earnings during their working years, which means they may not end up in a lower tax bracket after all. These higher-than-expected tax rates could cut into what they have budgeted for retirement and can be a startling realization for clients.

This is part of why Roth IRA conversions are an increasingly popular option. Taxes are still required to be paid, but the difference between this vehicle and a traditional 401(k) or traditional IRA is when clients pay taxes. With Roth IRA conversions, you owe taxes on the amount you convert and then that converted amount is able to continue growing tax-free. Plus you do not pay taxes at the time of withdrawals. While the tax hit can be tough to swallow on the front end, we’ve seen many clients take this approach to help protect a long-term investment from being heavily taxed down the road.

Take this example: A client of mine in her 50s has $1 million in a traditional IRA. She opted to convert it to a Roth IRA. Doing so required her to write a check for $500,000 to pay the taxes on these funds on the front end instead of when she takes a distribution or when her beneficiaries inherit the account.

It’s important to note that a Roth IRA must be open for five years and the individual must be at least 59-1/2 years old. But our client decided she would rather pay the taxes now and know that she has a completely tax-free asset that she can either lean on during retirement, or pass down to her heirs.

Maximizing charitable giving

Charitable giving as a tax strategy has become a more prominent conversation as well. Historically, clients would fulfill their charitable wishes by just writing a check to the organization of their choice. Today, however, there are many ways clients can be charitable and utilize new tools for tax exemptions.

A donor-advised fund, or DAF, is one of those popular tools. Donor Advised Funds are third-party funds that are created for the purposes of giving to charity. Let’s say you’re in a higher income earning year because you inherited money or sold a business, therefore triggering additional income tax. If you contribute funds to a donor-advised fund, you get a tax break because that contribution gives you a full tax deduction regardless of whether any of the funds have been distributed to charity that year. And if you’re planning to retire soon, this helps you continue to give at preretirement levels even though you won’t have the same steady income. Donor Advised Funds also have the benefit of involving family in giving and passing stewardship values on to multiple generations.

The other tool that clients have been utilizing for charitable giving is Required Minimum Distributions (RMD). Your required minimum distribution is the minimum amount you must withdraw from your Traditional IRA each year. Those withdrawals are included in your taxable income — unless you donate those funds. Like donor-advised funds, giving your RMD amount to charity helps you fulfill your charitable wishes and reduces your tax bill.

‘Giving while living’ to family and friends

Giving while living is another strategy rising in popularity and feasibility among clients and we expect it to continue to do so as one of the proposals last year was a reduction in how much wealth you can pass down, tax-free.

With our wealth planning tools, we’re able to illustrate income, tax liability and estimated amounts after a client has passed away, then we can discuss strategies we can implement today to help minimize estate taxes. As a result, our clients are now deciding to make gift contributions to their family members while they themselves are still living. Under current laws, a person can give up to $16,000 to any other individual annually, whether that’s a child, grandchild, nephew or friend. This money is then moved out of the client’s estate, therefore not taxed, and the recipient receives the full amount of the gift.

The notion of giving during a person’s lifetime has become popular not simply because of tax benefits, but because clients want to reap the rewards of seeing the impact their gift can have on loved ones. I recently received an email from a client who told me he gave $15,000 to his daughter as a Hanukkah gift. She loves music and ended up using it for music lessons. It was so moving to see him experience the joy of watching his daughter benefit from that money for months or even years to come.

These four tax strategies are among the ways our team has been managing assets for clients. We don’t just trade stocks, we also focus on client priorities, plans for their families, their goals and their desire to contribute to charity.

Ann Marie Etergino is managing director – financial advisor, RBC Wealth Management.

RBC Wealth Management does not provide tax or legal advice. All decisions regarding the tax or legal implications of your investments should be made in consultation with your independent tax or legal advisor.

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