Are you making tax planning decisions based on myths?

This article originally appeared in Aldrich Community, a client experience offering from Aldrich Wealth.

As the clocks fall back, we spring into the holiday season. The holidays are known for their cheer, but they can also be hectic as we plan and prepare for celebrations, all the while trying not to drop the ball on year-end deadlines before the ball drops. Arguably, some of the most critical year-end deadlines are tax-related, so at Aldrich Wealth, we get lots of tax planning questions this time of year. 

For example, we recently sat down with a client who received an unexpected payout. Worried that the additional income would move her into a higher tax bracket for 2023, she’d asked whether she should donate to a charity to avoid a higher tax rate on all her income. Our feedback was twofold. First, while charitable donations provide an incentive for those who are charitably inclined, it doesn’t necessarily make sense to donate if the sole purpose is to avoid tax because of the way donations are accounted for. In other words, the tax “tail” should never wag the dog. Second, because tax brackets are progressive, only dollars earned beyond the stated limit for a given tax bracket will be taxed at that higher rate. 

Reflecting on this conversation and countless similar questions, we thought it would be fun to kick off tax planning season by sharing a short list of common tax misconceptions and the rules behind them. Have you busted any of these tax myths? 

While the transfer of a home to an heir both in life and at passing may use the same amount of the lifetime exemptions for gift and estate tax purposes, the cost basis for the recipient is treated differently in these two scenarios. For properties gifted during life, the recipient will inherit the original owner’s cost basis, whereas, for properties inherited at the owner’s passing, the recipient will receive a step up in cost basis to the fair market value as of the owner’s date of death. As a result, the recipient of property gifted during life will have substantially more capital gains at the time of sale than a recipient who inherited the same property. If the parent donor intends to occupy the property after the gift has been made, additional consideration is necessary.

A tax deduction reduces taxable income, which does not provide dollar-for-dollar savings. Instead, the savings from an income tax deduction are equal to your marginal tax rate multiplied by the reduction of income. Let’s take, for example, a single filer with $100,000 of taxable wages who has $14,000 of itemized deductions before donating to charity. As you’ll see in the two scenarios below, adding a $5,000 charitable donation only saves this filer $1,100 in federal tax due, or 22% of the donation amount. 

Scenario 1 – baseline 

$100,000 AGI – $14,000 itemized deductions = $86,000 taxable income = $14,228 of federal taxes 

Scenario 2 – $5,000 charitable donation 

$100,000 AGI – $19,000 itemized deductions = $81,000 taxable income = $13,128 of federal taxes 

There is no increase in the likelihood of being audited because you filed for an extension on your taxes. In fact, extensions are often necessary for your tax advisors to provide you with the best guidance and planning services. For example, if you have ownership in a pass-through business or certain investments, the K-1 issued by the business may not be finalized until after the April 15 deadline. That said, it is important to keep in mind that this is only an extension of the due date to file your tax return—the deadline to pay your taxes will still be the original filing deadline, and your tax advisor still needs access to your tax information early in the year to compute your extension payments. The April 15 deadline is also important as it is the hard cutoff point to make certain tax-advantageous contributions for the prior tax year, such as contributions to your IRA or HSA. 

A QCD, or Qualified Charitable Donation, is a great tool for the charitably inclined. QCDs allow owners of retirement accounts such as IRAs to donate up to $100,000 pre-tax dollars to qualifying charities. Plus, these donations can count towards the account owner’s Required Minimum Distributions. It is a “win-win” situation since the non-profit organization also won’t owe tax on the funds received. QCDs are subject to several restrictions, though. Account owners must be 70.5 years old to use this strategy. Additionally, donations must come directly from retirement accounts; QCDs cannot come from a personal checking account. Finally, QCDs can only be donated to qualifying charitable organizations. This excludes many political organizations or political action committees that do not have such a tax status, even if their mission aligns with a donor’s values. 

The unified tax credit, more commonly referred to as the basic exclusion amount (BEA), represents the lifetime exemption for gift and estate tax purposes available to an individual. The credit was established with the objective of imposing taxes on assets once within a generation. Consequently, this unified tax credit encompasses all gifts made during an individual’s lifetime (inter-vivos) as well as testamentary transfers upon their passing. In 2023, individuals can bestow up to $17,000 per person annually without affecting their unified credit; this credit will increase to $18,000 per person on January 1, 2024. Should a single person exceed this gift limit when giving to another individual, they must file a gift tax return, and any amount surpassing the annual exclusion of $17,000 in 2023 per recipient will reduce the donor’s unified credit (lifetime exemption available) at the time of their passing. 

For those who pass away in 2023, the available unified tax credit stands at $12,920,000. This credit is slated to decrease to $5,000,000, adjusted for inflation, in 2026. Fortunately, the Internal Revenue Service has announced that individuals who take advantage of the current heightened gift and estate tax exclusion amounts by making inter-vivos gifts will not be subject to the reduction when the exclusion diminishes in 2026. Taxpayers will have the flexibility to calculate the estate tax credit using the higher of the BEA (unified credit) applicable during their lifetime or the BEA applicable on the date of their death. With this in mind, now is a great opportunity to connect with your advisor to consider whether it may make sense to gift certain assets during your lifetime. 

For sales of primary residences, the IRS provides an exclusion of income in certain circumstances. For Married Filing Joint taxpayers that have lived in their home for two of the last five years, the IRS allows the first $500,000 of gain ($250,000 for Single) to be excluded at sale. This exclusion can be used once every two years. There used to be a provision to defer gains on the sale of primary residences, but that provision has been repealed. We recommend retaining copies of all purchase agreements and invoices on improvements to your home to substantiate your cost basis in the future. 

It is also important to note that a parent cannot gift a home to a child during his or her lifetime and continue to live in that home without use of a special trust (Qualified Personal Residence Trust, or QPRT). Attempting to do so will pull the value of the home back into the estate of the donor. 

It’s often possible that your itemized deductions do not exceed the Standard Deduction for federal income tax purposes. When this situation occurs, it will reduce your effective tax savings when incurring additional costs that would otherwise be classified as itemized deductions. If we assume the same scenario previously discussed but reduce the amount of itemized deductions prior to charitable contributions to $10,000, we will see a reduced tax savings when the additional $5,000 charitable contribution is made. The federal tax savings between Scenarios 3 and 4 is only $253, or 0.5%. 

Scenario 3 – Reduced itemized deductions to $10,000 

$100,000 AGI – $13,850 standard deductions = $86,150 taxable income = $14,261 of federal taxes 

Scenario 4 – $5,000 charitable donation 

$100,000 AGI – $15,000 itemized deductions = $85,000 taxable income = $14,008 of federal taxes 

If you find yourself in this situation, your advisor may recommend tax strategies to maximize the value of your deductions. This is often done by “bunching” charitable donations into one tax year via the use of a Donor Advised Fund. By bunching charitable donations, you can maximize your standard deduction in year one and your itemized deductions in year two, or vice versa. 

All taxpayers are required to make regular, periodic payments of their taxes. For most individuals, this is achieved through withholdings on wages or retirement payments. For others, this can be done by making direct quarterly estimated tax payments. It is recommended to be on top of these estimates to prevent underpayment penalties and/or interest charges. The federal interest rate is adjusted quarterly and is an annual rate of 8% as of the date of this writing. State and local tax jurisdictions may have rates different from the federal interest rate. 

The amount of tax paid throughout the year is generally determined by one of two methods. First is the determination of 90% of your current year’s taxes and ensuring that it is paid throughout the year. Depending on the variability of your income, this may be hard to achieve. The second method is offered as a “Safe Harbor” to help reduce the variability of payments due to changing income levels. For federal purposes, the Safe Harbor is calculated by taking your prior year’s total tax and multiplying it by 100% (or 110% in the case of years when your Adjusted Gross Income (AGI) is over $150,000). 

Please note that depending on jurisdiction and income level, the Safe Harbor calculation will vary for state purposes. 

Once we get to April 15 and the original filing deadline of your return, your CPA will review all the finalized data received, work with you in making an estimate of income still to be reported (if needed), and compute the projected balance of tax due, if any. This extension payment is an estimate of tax, so your tax computations may change depending on how additional information is incorporated into your tax return; if your tax liability increases, additional taxes, interest, and/or penalties may be due. To mitigate this negative risk, we recommend being conservative and overpaying your taxes at an extension. Any amounts overpaid may be requested as a refund with the filing of your return or applied to a future tax year. As we are doing these calculations, we are also considering the need for your future year tax estimates. 

There are many great organizations in the US that are serving communities, and it can often be hard to determine which organizations qualify for tax-deductible donations. If you have questions about the deductibility of your contributions to any given organization, we recommend looking at their website. Many organizations clearly state their exempt status to gather financial support from the public. If you are not able to find information on the organization’s website, you can use the IRS’s search tool or Candid’s search tool. 

QCDs are an excellent way to manage your tax bracket and support charitable organizations, as you are able to reduce your Adjusted Gross Income (AGI) and any tax associated with your AGI. Most commonly, this could be the amount of income subject to the 3.8% Net Investment Income Tax. Additionally, you may be able to receive other federal, state, or local benefits with a reduced AGI. An example of a federal benefit could be reducing your Medicare Part B premium to a lower bracket. 

We do not recommend using a QCD when participating in charity auctions or tax credit programs where you receive a state tax credit in a quid pro quo exchange of goods or services. Use the QCD when you are making direct charitable contributions to the organization. You should also request a receipt for your donation. 

No matter how cut and dry a tax rule appears, the rule’s impact can vary significantly based on each filer’s unique situation. Of course, you can always reach out to one of our advisors to get a better understanding of how these rules apply to you.