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End of year planning: Gifting, 529's, Taxes, and Donor Advised Funds Thumbnail

End of year planning: Gifting, 529's, Taxes, and Donor Advised Funds

As the end of year approaches, I thought it would be helpful to lay out some ideas and thoughts around gifting money and how it factors into your broader plan. 

As always, if you want to discuss any of this further, if you are an existing client we’re always here to review! If you would like to create a Financial Life Plan that factors in your gifting strategy, you can schedule a "Right Fit" call with me.

How do charitable donations work?

If you’re pondering making a donation to charity the reason for doing so must be because you WANT to donate to a cause you care about, and NOT for the tax deduction that you’ll ultimately receive. After all, the deduction is nice, but it doesn’t offset the gift itself! If you donate $1, you’ll receive tax savings of 30 cents (just an average estimate) but you’re still giving away the full dollar! As such, donations are fundamentally a values/cash flow decision and not a tax decision. 

Moreover, you only get a deduction for charitable contributions if you itemize on your tax return and less than 10% of tax payers do so (though admittedly higher income folks and small business owners are more likely to itemize than the general public.) As a brief refresh, you can either take the standard deduction ($12,950 and $25,900 if married) or you can itemize your deductions if itemizing would come out to more than the standard deduction. If you take the standard deduction than you get no tax benefit for charitable giving in 2022. 

How can I gift money to family?

This comes up all the time and I think there’s some confusion as to how gifting & receiving gifts work. If you are the recipient of a gift (say your parents are gifting you money for their grandchildren), there is nothing that you have to do: no filing and no taxes to be paid upon receiving the money. This is because it’s the person making the gift that must be aware of the tax ramification and not the recipient.

Here’s how gifting works for the person making the gift:

You can give $16g per person ($32k for a married couple) without having to file a gift return or running into any tax questions at all. Now, if you give away more than $16k, you have to a file an additional tax form, form 709, but it doesn’t mean that you owe any additional taxes this year….it just means that the excess above $16g that you gave away will come out of your lifetime gift & estate tax exemption.

The current estate exemption if $12,060,000 ($24,120,000 if married filing jointly) so it’s not relevant to all but the highest net worth families….(though this can always be changed…In fact, back in 2017, before the Tax Cut and Jobs Act, the exemption was only $5,450,000.) As an example, you decide to gift $116k to family this year, you will have to file the additional tax form and the excess $100k gets reported and will lower your lifetime gift/estate exemption from $12,060,000 o $11,940,000. 

529 Plan Contributions: 

529 plans, as a way of saving for education, doesn’t exactly fall into this gifting category but as does have a December 31st deadline for annual contributions, I thought it worth discussing. (It also quite literally is considered a gift for the purposes of the $16,000 limit and the lifetime exemption rules that we just discussed.)

529 plan contributions grow tax-free and will be distributed tax free if they are used for qualified education purposes (tuition, room and board, books etc.). This might be an aside, but you’re actually able to change beneficiaries/ownership of 59 plans without running into any tax issues. For example, my dad set up 529 plans for my sister and I when we were young. He ended up not needing to use the 529 plans for us, and instead he’s let the plan continue growing tax-free in the decade since we finished school. 

Then, last year, when my sister had her first child Bodhi, my dad made my sister the owner of her 529 plan and they made my nephew Bodhi the beneficiary. What does this do for them? They now get an additional 18 years of tax-free growth before Gabby (my sister) can use the funds for her son’s college. If Bodhi were to get a scholarship or she chooses not to use the 529 funds for him, she can make her second child the beneficiary. This is all a digression (hopefully a thought provoking one) but the point is that there is a lot more flexibility to 529 plans than people think.

Here's what matters for the purpose of your end-of-year contributions. First off, 529 plans are not federally tax deductible, so you do not save any money on your federal tax return by contributing to a 529 plan. But, and here’s the piece that’s relevant, most states do offer a state income tax deduction for contributions to 529 plans up to a certain contribution amount. Every state has it’s own rules, and in some states the deduction only applies if you use the state’s specific plan, but we’ll just run through a few example as an overview: 

Florida, Texas, Washington, Tennessee, Wyoming, South Dakota, Nevada, and Alaska all don’t have state income taxes (congrats to all of you living in these states) so naturally there is no deduction for 529 contributions. 

New York - Up to $5k ($10k if married) of plan contributions are deductible on your New York Tax return

New Jersey- Up to $10k ($20k if married) of plan contributions are deductible on your New Jersey Tax Return

Pennsylvania- Up to $16k ($32k if married) of plan contributions are deductible on your Pennsylvania Tax Return (so the full amount of your annual gifting amount)

California- No state income tax deduction 

Massachusetts- Only $1k ($2k if married filing jointly) of plan contributions are deductible on your Massachusetts Tax Return

Minnesota- Only $1.5k ($3k if married filing jointly) of plan contributions are deductible on your Minnesota Tax Return

How do Donor Advised Funds work? 

Donor Advised Funds have become very popular over the last few years and with good reason. A donor advised fund is a type of investment account that you deposit assets into for the explicit purpose of making a full donation to charity over time. When you contribute money to a Donor Advised Fund, you get a tax deduction in the current year full the full contribution….even if you wait a few years to disperse the money from the fund and to a specific charity. You get the full deduction up front because once you contribute the funds to the Donor Advised Fund, it is NO LONGER YOUR MONEY. You have made an irrevocable gift to the fund, and it can only be used towards IRS approved charities.

So if let’s say you want to make a donation of $50k this year but you’re unsure which charities that you want to donate to or when exactly you want to donate the money. Well, you can contribute the full $50k to your Donor Advised Fund, receive the $50k tax deduction for 2022, and then decide over the next few years how much you want to give, to whom, and when. The funds inside of Donor Advised Funds will grow tax free until you are ready to disburse the funds. 

Sometimes it can make sense to put highly appreciated stock into a Donor Advised Fund because you get the tax deduction for the current value of your donation, and you won’t pay capital gains on the appreciated stock that you’re putting into the Donor Advised Fund. So if you want to donate $100k and you have stock that’s worth $100k but you only paid $20k for it, you may decide to offload the $100k into the Donor Advised Fund. The charity will receive the full $100k you wanted to give away anyway, you will get the deduction for the full $100k of value that you contributed, and you don’t have to worry about ever having to pay the capital gains on the stock. (Of course, it may just be a really great holding that you want to keep but that’s a separate investment conversation.)