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Friday, May 5, 2017

A Case Study for Bunching Itemized Deductions

Meet the Washingtons
Donald and Hillary Washington are a retired couple in Texas (both distinguished public servants) living primarily off investment and retirement income. They have paid off the mortgage on their $400,000 home.  Their marginal tax rate is 25%, meaning the next dollar they earn is taxed at 25%, and the next dollar they can deduct saves them 25 cents in taxes.

They make charitable contributions of $5,000 a year, and the annual property taxes on their home are $9,000. For simplicity, I will disregard other common itemized deductions, such as medical expenses, state sales tax and investment management fees. 

As you probably already know, the tax code allows the Washingtons to deduct on their joint tax return either the standard deduction amount or the sum of their itemized deductions for the year, whichever is greater.  They don’t have to make any payments to receive the standard deduction.  They get it simply by drawing breath in that tax year. Their standard deduction amount for 2016 is $12,600.

Non-bunching results:
Their calendar 2016 itemized deductions are $14,000.  Tax savings at 25% are $3,500. Calendar 2017 tax savings are the same: $3,500. (I am ignoring any potential inflation adjustments.) Two-year tax savings from these deductions total $7,000 – not bad!

Bunching results:
Assume that 2016 is the “on” year.  The Washingtons pay their 2015 property taxes in January 2016 and their 2016 property taxes in December 2016.  (The flexibility we have in Texas to pay our property taxes in December or January without penalty is a key success factor for the bunching strategy; talk to your advisor about the rules in your state.) Similarly, they double up on their charitable giving in 2016, with the idea that they will make no charitable donations in calendar 2017.

Calendar 2016 itemized deductions are $28,000 (double!).  Tax savings at 25% are $7,000 (double!). For calendar 2017, they use the standard deduction of $12,600, and tax savings are $3,150. Two-year tax savings (from making the same payments as before with slightly different timing) are now $10,150 – much better!  This strategy can be employed for many years.

The reason this works so well is that the incremental benefit of paying $14,000 a year in deductions when your standard deduction is already $12,600 is only an extra $1,400 of deductions – producing tax savings of only $350.

Using a donor advised fund (DAF) through a local community foundation is a convenient way to deal with the timing issues of bunching charitable giving.  In our case study, the Washingtons could donate $10,000 to their DAF in the “on” year.  They could then use their DAF to fund payments to their charities throughout the “on” year and the “off” year.  Even though the Washingtons have chosen to bunch, their charities can receive their funding in their normal annual time frame.

They save even more tax dollars by making their gifts into their DAF (only during “on” years!) using appreciated stocks from their brokerage accounts.   A gift of a marketable security held long-term produces a fair market value tax deduction but avoids recognition of the gain on the appreciated stock position.

The Washingtons illustrate the classic bunching example of a retired couple whose home is paid off, but the strategy can be effective in other fact patterns, as well. Note that property taxes are one of the deductions that are disallowed under the alternative minimum tax (AMT), so occasionally AMT will reduce the effectiveness of the bunching strategy.

As always, please chat with your Armanino advisor to determine whether you could benefit from bunching the way the Washingtons do.


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