Rich Kids, Poor Kids (Part 2)
Bert Whitehead, M.B.A., J.D. ©2014
This is the second of three related blogs covering a broad topic:
- Part 1: A View of our World Through our Grandchildren's Eyes in 100 Years
- Part 2: Intergenerational Tax and Financial Strategies to Leave a Family Legacy
- Part 3: The Most Important Lesson to Teach Our Children Now
As discussed in the previous blog, our society is increasingly split between rich kids with a good educational and health foundation, and poor kids with a disadvantaged upbringing likely to hinder their futures. While we can’t restructure dysfunctional families, we can do our best to ease the way for our own children and grandchildren.
We send the best and brightest in our society to Washington to figure out what policies we need to become a better country. Frequently these policies are structured as tax incentives that reward specific financial actions. I believe that those of us who learn about these tax policies and follow the will of Congress are acting in the most patriotic way possible. I suggest three strategies for consideration: Donor Advised Funds, Roth conversions and Intergenerational Strategies.
Donor Advised Funds for Tax Benefits and Philanthropic Options
Donor Advised Funds (DAF) enable individuals and families to set aside funds, tax-free, under the umbrella of a 501(c)3 nonprofit foundation. Most brokerage companies (Schwab, Fidelity, etc.) and many large non-profit and community organizations (Jewish Federation, Southeast Michigan Community Foundation, etc.) offer these DAFs to all individuals at a nominal cost. Each DAF manages its funds, directing contributions to nonprofit groups chosen by the donor(s).
For taxpayers in the top tax bracket, giving $1,000 in cash to a DAF results in a $400 tax saving. However, if $1,000 in appreciated stock is donated to a Donor Advised Fund, the donor saves $400 through the income tax deduction and up to an additional $200 by avoiding the capital gains tax on the appreciated stock.
Our society depends on taking care of one another and these tax incentives make philanthropy more financially appealing. When my family gets together annually, each member identifies a nonprofit organization for a $100 deduction from the Whitehead Donor Advised Fund, and we make the grants online accordingly. When older grandchildren are away at school or jobs and unable to join us, they email me their choices for charities. This is a good way to develop a family commitment to help others.
Another way to save taxes for future generations is to convert IRAs to Roth IRAs. The money converted to the Roth IRA is taxed now, and future earnings accrue totally tax-free. Withdrawals after retirement age are not taxed, and there is no required minimum distribution, which is normally required at age 70 1/2. Upon the death of the taxpayer, the spouse pays no income tax as the beneficiary of a Roth IRA. After the death of the second spouse the Roth IRA accounts can be passed on to their children, who will also receive the distribution from the Roth IRA tax-free. They can then elect to withdraw it gradually, with the minimum required distribution based on their life expectancy at the time they inherit the Roth IRA.
When IRA funds are converted to a Roth IRA, the transferred funds are subject to taxation as ordinary income. Generally conversions are made after significant wealth has accumulated and the taxpayer is in a much higher bracket. This disincentive to elect Roth IRA conversions can be mollified, however, with astute tax planning.
For example, while high income taxpayers are not allowed to contribute directly to Roth IRAs, they can fund non-deductible IRAs (the maximum contribution is currently $6,500 per year). The non-deductible IRA does not provide a tax benefit other than that the earnings accrue tax-deferred. The significant tax advantage is that the IRA can be converted later to a Roth IRA and taxes are assessed only on the accumulated earnings, not the original basis.
Intergenerational Tax Strategies
The creation of a Donor Advised Fund and conversion of an IRA to a Roth IRA can be combined for maximum tax benefit. By establishing a DAF, the tax deductions for the funds contributed to it can offset taxes on the funds converted to a Roth IRA.
Establishing a DAF and utilizing Roth Conversions are very effective ways to pass on our philanthropic values and conserve assets for future generations of our families.
Since these strategies can be somewhat complex, it is important to work with a tax professional to implement them correctly.