Financial Planning Archives - Setarcos LLC

The Tax Benefits of Donating Appreciated Stock to a DAF

evanhall — Mon, 05 Dec 2022 18:00:23 +0000

Updated: December 5, 2022

Donor Advised Funds (or DAFs) are an increasingly popular way to make charitable donations to 501(c)(3) organizations. The reasons for their popularity include:

Being able to donate to the DAF today and recommend which charity (or charities) receive the funds in the future
Receiving a charitable tax deduction in the year that you give to the DAF, not in the year that you distribute the funds to the charity (note: in order to utilize the deduction, you must itemize your deductions rather than take the standard deduction)
Investing undistributed funds while they remain in the DAF
Last, by not least, there can be significant tax advantages when you donate appreciated stock rather than cash to your DAF

Regarding the last point, let’s look at an example. We’ll assume you bought a share of stock for $50 and you held it until it reached $100 today.

Also, we’ll assume the highest marginal tax rates apply:

Federal ordinary income of 37%
California state income state of 12.3% (applicable to both ordinary and capital gains)
Federal long-term capital gains of 20%

Federal investment income tax (ACA tax) on sale of stock of 3.8%

When you donate to charity (or a DAF) you receive a tax deduction in the amount of the donation. You receive the same tax deduction whether you donate $100 of cash or a $100 of stock. However, when you donate appreciated stock, you never pay the tax on the capital gain, which is why donating appreciated stock is usually better than donating cash.

Let’s compare the two options using the assumptions.

As shown in the table below, donating $100 cash (Option 1) will actually cost you $50.70 since you save $49.30 in taxes from the charitable tax deduction. But what if you donate $100 of the appreciated stock (Option 2)? You still receive the same charitable tax deduction, but you also avoid the tax on the capital gain of $18.05. When you add those two benefits, the cost of donating the stock goes down to $32.65. The difference is the result of avoiding the capital gains tax!

Now, what if you assume you donate stock that has appreciated less and lower marginal tax brackets? These assumptions would reduce the tax benefit of donating the appreciated stock. But the larger point still remains: donating appreciated stock is usually more tax efficient than donating cash because you’re avoiding the tax on the gain (assuming you don’t exceed the limitations on stock donations).

You can read more about DAFs here. Let us know if you’d like to further discuss all the benefits of opening a DAF and/or gifting strategies to maximize the tax benefits.

Disclosures:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index. Past performance shown is not indicative of future results, which could differ substantially. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of Setarcos strategies are disclosed in the publicly available Form ADV Part 2A.

Setarcos Wealth Advisors LLC (“Setarcos”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Setarcos and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at setarcosllc.com.

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Plan > No Plan

evanhall — Mon, 10 Oct 2022 18:00:33 +0000

I was recently having dinner with a friend when she asked me a basic question about her and her husband’s financial situation. They have been saving diligently for years and she wanted to know if it was okay to put off saving for a few years in order to spend on a few large discretionary items.

The question seemed straight-forward enough. If they want to safely retire at a (relatively) young age, they’d had better save as much as possible and be careful not to dip into their savings too much. On the other hand, I thought, if they’ve been putting money away for many years, perhaps they’ve already saved enough for retirement. Wouldn’t that be nice!

Of course, without knowing anything about their financial situation I wasn’t able to answer the question. But I could lead them in the right direction with another question.

So, I asked her a simple follow-up: do you have a financial plan? Well, she said, “we have an advisor who helps us invest, but we don’t have a financial plan.”

Now, I’m not sure why one would pay an advisor who hasn’t helped you develop a financial plan. But, that’s a topic for a different day.

The point I want to make is that even a foundational financial plan would have helped answer my friend’s question. Put simply: even a basic financial plan is better than no plan at all!

A financial plan fundamentally gets you from Point A to Point B (and at a minimum, Point B is a desired retirement age with a comfortable standard of living). Planning is analogous to navigating, which is why it’s so critical. However, often couples and families are directionless because they fail to define and communicate their goals in the first place – determining what Point B looks like!

As advisors, our job is to engage our clients to start planning – what I like to think of as a process of clarity – and to help them successfully reach their goals. While our financial expertise is important, our value is often also behavioral in nature: to help clients take action.

So, the best answer I could give my friend was to take the first step. Engage an independent advisor to develop a plan. The benefits of having clarity and confidence in your financial decisions should far outweigh the costs.

Disclosures:

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Financial Planning in Monte Carlo

evanhall — Tue, 16 Aug 2022 18:30:34 +0000

In my last blog post, I talked about the importance of having a financial plan that gets you from point A to point B. And, at a minimum point B includes your fundamental goals of a desired retirement age and standard of living. A sound plan provides you a high degree of confidence (or, high probability of success) in execution. Developing this confidence is the basis of this post.

First, how do you get from point A to point B in your plan? Generally, you save and invest during your working years to create a portfolio that will fund your living expenses and goals in retirement. A plan assumes a certain level of savings and, just as importantly, a constant investment return that grows those savings. Simple enough, but is a constant rate of return realistic? Not at all, obviously, if you follow the stock market just a little bit.

While returns have historically increased over long time periods, in reality they are not predictable from year-to-year (you can read more about this here). For example, let’s look at the one-year returns for the S&P 500 for three randomly chosen five-year periods:

Years	Sequence of Returns (rounded to nearest percentage point)
1970 – 1974	+4%, +14%, +19%, -15%, -27%
1990 – 1994	-3%, +31%, +8%, +10%, +1%
2005 – 2009	+5%, +16%, +6%, -37%, +27%

Source: Dimensional Fund Advisors “Matrix Book 2018”

Not exactly constant returns! Stock market returns are essentially random in any one-year period. The risk posed by this random up-and-down pattern of returns is referred to as sequence of returns risk and can impact your financial plan in various ways (both negatively and positively). Ongoing withdrawals and bad early returns in retirement could result in a depleted portfolio before the end of your life. As advisors, one of our priorities is to focus on understanding the potential likelihood of negative planning outcomes associated with this sequence of returns risk.

How do we do that? When we develop a financial plan, one tool we use is called Monte Carlo simulation which simulates thousands of random sequences of investment returns over the term of the plan. The result of running these simulations is a set of potential projected planning outcomes. From that distribution of outcomes, we can develop an estimated confidence level of a financial plan being successful (i.e., not running out of money). For example, if 10% of the simulations resulted in your plan running out of money, you have a 90% probability of success – high enough to implement the plan.

What if our client’s plan has a low probability of success? In this case, we collaborate to restructure the plan until we achieve a satisfactory probability of success. Options include prioritizing and modifying financial goals, increasing savings and changing the strategic investment allocation. The plan is not a good plan until we have high degree of confidence in it.

Now, it’s important to keep in mind that, as with all financial modeling techniques, Monte Carlo modeling has plenty of limitations. However, if you are aware of those limitations and can interpret the results within the context of those limitations and the overall financial planning model, Monte Carlo modeling can be an indispensable tool in evaluating the strength of your plan.

So, I’ll pose this question to you: what is the probability of success of your financial plan? If you don’t know, let’s begin the conversation.

[1] I’ve used estimated earnings per share for Q1 of this year (source: S&P) in all calculations since actual results for Q1 have not yet been fully reported.

Disclosures:

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Roth IRA Conversions in Declining Markets

evanhall — Tue, 05 Jul 2022 18:00:54 +0000

Market declines are painful. When they happen (as they are in 2022), you’ll often see recommendations to take advantage of the decline (e.g., tax-loss harvesting). Most of these recommendations are value-adding, however, we often see one with which we disagree: to do a Roth conversion after a market decline.

To make our view on this clear: we do not recommend converting your traditional IRA money to Roth IRA money (i.e., doing a ‘Roth conversion’) solely because markets have declined.

To understand why, let’s first consider the reasoning often used to justify the recommendation to convert in a market decline. It goes like this: when markets decline, your IRA balance is lower today than it was before the market fell; therefore if you convert today, you will pay less in tax dollars than if you converted before the market fell. This is true, but it does not justify a conversion. The focus of a conversion should be on tax rates not dollars paid. If dollars paid were the reason to convert, the following conclusion would be reached:

If the goal is to minimize the tax dollars paid on conversion, then you should convert today if you think your IRA balance might ever be higher
Therefore, since you will obviously assume your IRA balance will grow in the future, you should convert all your IRA money today and never hold traditional IRA money (even if the market didn’t decline!)

To be clear, again, we don’t recommend doing this.

In fact, where the market has been in the past has no bearing on the Roth conversion decision. Instead, the primary driver of this decision is a comparison of your current and future tax rates. Paying less taxes today when the market declines will still be worse economically if your tax rate today is higher than the future. To help illustrate why, let’s first back up and review the tax benefits of IRA accounts and how those relate to Roth conversions.

There are two types of Individual Retirement Accounts (or IRAs): Traditional IRAs (which consist of pre-tax money) and Roth IRAs (which consist of after-tax money). When you contribute to a Traditional IRA, you receive a tax deduction and the account grows tax-deferred. When you eventually take a withdrawal, you’ll owe taxes based on your marginal tax rate in the year of withdrawal. A Roth IRA works in the opposite way. There’s no tax deduction when you contribute, but the account growth and withdrawals are tax free.

If you’re in a higher tax bracket today compared to your estimated tax rate in the future when you plan to make withdrawals, it makes sense to contribute to a Traditional IRA (assuming you’re eligible). For example, if you’re in the 32% tax bracket today and estimated to be in the 22% bracket in the future, you’ll save 10 cents on every dollar you contribute. In other words, for every $1 you contribute today you’ll avoid 32 cents in taxes and then pay 22 cents in taxes when you make a withdrawal – that’s a net 10 percent savings!

If you’re in a lower tax bracket today than you would be in the future, a Roth makes sense. For example, if your marginal tax rate is 22% today but will be 32% in the future, you’d be better off making a Roth contribution (forgo a deduction worth 22 cents for every $1 you contribute) while avoiding taxes in the future (32 cents). Again, you’ll save a net 10 percent if you do this correctly.

For most wage earners near the middle or end of their career, their tax rate will likely be higher while they’re working than when they retire and have lower income.

Now, let’s pivot to Roth conversions, which is transferring funds from your Traditional IRA to your Roth IRA and paying the taxes today to avoid them in the future. The same tax rate logic applies to the decision about whether to do a conversion. If you go back to my example in the previous paragraphs, paying taxes today makes sense when you are in a lower tax bracket than you expect to be in the future. If you’re in a higher tax bracket today than in the future, your savings becomes a loss. Finally, if you’re in the same tax bracket, you’d be indifferent.

As I also said, people are generally in higher tax brackets while they are working. So, converting tends to be a great strategy when you stop working and before you start taking Social Security. For example, if you’ve retired at age 60 and Social Security benefits won’t start until age 67 or 70, then you can likely convert at very low rates!

Throughout this explanation, notice that I haven’t said anything about where the market has been and whether your balance is higher or lower than it used to be. Again, that doesn’t impact this decision. Michael Kitces, an advisor to advisors, has written about this concept here:

There are only four factors that impact the wealth outcome when choosing between a Roth or traditional IRA (or other retirement account). They are: current vs future tax rates, the impact of required minimum distributions, the opportunity to avoid using up the contribution limit with an embedded tax liability, and the impact of state (but not Federal) estate taxes… By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates… The principle of this equation is remarkably straightforward – the greatest wealth is created by paying taxes when the rates are lowest.

Again, to put it simply, you should not do a Roth conversion just because your IRA balance is lower today than it was at some point in the past (all other things unchanged). In fact, if you weren’t planning on doing a Roth conversion before the market declined, doing a Roth conversion because markets have declined can actually cause permanent financial loss.

That final point is worth emphasizing. Investors can make an IRA conversion even worse if the amount they convert pushes them into a higher tax bracket. If, for example, you do a Roth conversion this year because markets are down, but that conversion pushes your tax rate up when your tax rate today is already higher than what you expect in the future, then you’ve paid an additional tax you never needed to pay. We’re pretty sure no one wants that outcome!

In summary, here’s what you should keep in mind when you hear about Roth conversions:

Don’t do a Roth conversion just because markets have declined
Converting too much may needlessly push you into a higher tax bracket and result in economic loss
They are tricky since they require building a financial plan that estimates your tax rate today versus your tax rate in the future
They are a valuable tax strategy when it makes sense to do them
You’ll likely have an opportunity to do them at some point so be patient and make sure you’ve evaluated your current and projected tax situation beforehand

As always, please reach out if you’d like to discuss.

Disclosures:

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