It’s the most wonderful time of the year… to give back!
The end of the year is a joyous time, filled with family and fun, snow for our northern friends and sand for us Floridians. It’s also a very popular time for charitable giving. In fact, 30 percent of all contributions happen in December. A full 10 percent of all donations occur during the last three days of the year.
While writing a check or clicking the donate button may seem like the easiest way to contribute to your favorite cause, you may be losing out on additional benefits — for you and your favorite charity — by not planning your contributions.
The Tax Cuts and Jobs Act (TCJA) of 2017, as well as the recently enacted Coronavirus Aid, Relief, and Economic Security (CARES) Act, introduced some new income and tax variables that need to be optimized to get the most bang for your charitable buck.
Let’s dive into five strategies that maximize the tax benefits to you while still supporting the causes you hold dear.
These strategies can be used in combination with each other to increase the mileage of your contributions. Of course, be sure to consult with your tax, legal, or financial advisor to discuss how these strategies can be best implemented within your financial life.
The Tax Cuts and Jobs Act of 2017 changed many facets of income tax planning. With the removal of personal exemptions and the increase in the standard deduction, almost 9 out of 10 households will simply take the larger standard deduction.
This change in filing strategy had the unintended consequence of reducing, or even eliminating, your ability to claim charitable deductions against your income. For instance, if the combination of all your potential itemized deductions is less than $24,800 in 2020 (for Married Filing Jointly (MFJ) filing status), you would simply take the standard deduction and get no tax benefit for your donation.
All is not lost, however. A popular strategy to clear the standard deduction hurdle is to bunch several years’ worth of donations into a single year. Let’s look at an example to illustrate the power of bunching.
The Millers are a married filing jointly household that typically makes $10,000 of charitable donations each year. Now assume their other potential itemized deductions — things like interest on their primary home mortgage and state and local taxes — total another $12,000. The total of all of the Millers’ potential itemized deductions ($22,000 in this case) is below the $24,800 standard deduction level. So, in any given year, the Millers would take the standard deduction since it’s larger than their itemized deductions.
But now let’s look over a multiyear horizon. If the Millers bunch together three years’ worth of charitable donations in one year, they can now itemize their deductions in year one and take the standard deduction in years two and three.
Total deductions over this three-year span equal $30,000 (bunched charitable donation in year one) + $12,000 (other itemized deductions in year one) + $49,600 (standard deduction in years two and three) = $91,600. Simply taking the standard deduction over those three years would equal $74,400. At a 24 percent federal bracket (ignoring state tax), the Millers would save $4,128 in taxes by using the bunching strategy.
Further, the CARES Act allows for an additional “above-the-line” deduction for charitable gifts made in cash of up to $300. If you are not itemizing on your 2020 taxes, you can claim this new deduction.
But what if you don’t like the idea of sending such a large check to your favorite charity in a single year, then sending nothing in the subsequent years? Thankfully, there is a way to use the bunching strategy while also smoothing out when the charity receives the donations.
A donor-advised fund (DAF) is a charitable account that is set up in your name but administered by another large nonprofit or charity (Schwab and Fidelity are two of the largest). Donor-advised funds are simple to set up and fund. You make an irrevocable donation to the DAF and receive an immediate tax deduction in return. The donor-advised fund will manage the money based on your investment preferences.
You also get to recommend when, where, and how much to send to an approved charity of your choice. Note, though, that the organization administering your account will perform due diligence on your suggested grantee to make sure they will be used for charitable purposes. The grantee also needs to be an IRS-qualified 501(c)3 public charity. Foundations and other charitable organizations generally cannot receive distributions from your donor-advised fund. There are also typically account minimums, though those vary by each organization administering the DAF. Additionally, there are fees (typically, asset-based percentage fees) to consider.
Donor-advised funds are an incredibly helpful tool when used in combination with the bunching strategy described previously, as well as part of advanced income tax planning strategies (discussed later in the article). For instance, in the previous bunching example, the Miller family could put that $30,000 into a donor-advised fund, and then disburse $10,000 each year to their approved public charity of choice.
Qualified Charitable Distributions
A qualified charitable distribution (QCD) can be a great option for those who are comfortable with their income in retirement and want to find a way to reduce the tax burden associated with required minimum distributions (RMDs) from retirement accounts. They are also a great option for those in retirement who may not want to, or have, the ability to make large single-year donations.
Despite the fact that RMDs were waived in 2020 as part of the CARES Act, you still can make a qualified charitable contribution from your IRA and reap the tax and philanthropic benefits. When you are eligible to take your RMD (in 2020, age 72 or older), you can instead donate some, all, or more of your RMD (up to the $100,000 annual limit) to a qualified public charity.
But why not just take the required minimum distribution and donate the funds after the fact?
While it may seem easier to take your RMD as usual and simply donate the funds directly to your favorite charity, you run the risk of increasing other taxes and premiums. RMDs increase ordinary taxable income, as well as modified adjusted gross income. Taking RMDs in this manner can potentially increase your marginal tax bracket, trigger a Medicare surtax, or raise your Medicare Part B and D premiums. QCDs are excluded from taxable income, avoiding the potential tax pitfalls mentioned above.
You must carefully plan how and when you implement a QCD strategy. The first money out of a retirement account is considered the RMD, so if you have already started taking monthly distributions, you may have lost some of the ability to harvest the tax benefits mentioned above. Additionally, you cannot take your QCD and place it into a DAF. And, lastly, you cannot receive any benefit from the charity for your QCD, no matter how small or indirect. Don’t let a free coffee cup disqualify your donation!
What Assets Should I Donate to Charity?
Now that we’ve covered some of the more common methods of maximizing the impact of your charitable donations, let’s go over the types of assets that you can donate. It’s easiest to break these down into two major categories: cash and non-cash. Non-cash assets can further be broken down into liquid assets (like marketable securities such as publicly traded stocks and bonds) and complex assets (such as real estate, non-publicly traded stock, small business interests, insurance policies, collectibles, etc.).
For most cash donations, the total amount of your contributions that can be deducted used to be limited to 60 percent of your adjusted gross income (AGI). The CARES Act changed the percentage to 100 percent for 2020 only.
For cash donations, it’s best practice to always ask for a receipt. Cash donations need to be substantiated by some record, whether it’s a canceled check or credit card receipt. For donations of $250 or more, you will also need an acknowledgment from the charity that states the amount you contributed, the description of the donation, and whether or not you received any goods or services in return for the contribution.
Non-cash assets are typically limited to 30 percent of your AGI, assuming that you’ve held the asset for more than one year. You are able to deduct the fair market value of the asset — again, up to 30 percent of your AGI — and you can also carry forward any excess above that limit for five years.
The distinction between liquid and complex assets comes down to determining the market value of the asset. With public stocks and bonds, the price of the security should be readily apparent. However, that is not the case for complex assets like artwork or small business stock. For non-cash gifts worth more than $5,000, you will need to get a qualified appraisal and submit a Form 8283 with your tax return to document the fair market value of the asset.
Advanced Charitable Giving Strategies
Creative planning opportunities abound when you start integrating charitable intent with other aspects of your financial life. For instance, if you are charitably inclined and are at or close to retiring but not yet at your RMD age, you may be able to do partial Roth conversions of your tax-deferred accounts and offset some of the additional taxes due by making charitable contributions using the methods described above.
There are also unique ways to mitigate income or capital gains tax by timing your donation with a business sale or donating highly appreciated securities, though there are tripping points and other considerations that you must navigate.
Additionally, you can integrate different trusts, like charitable remainder trusts (CRT) or charitable lead trusts (CLT), into your estate plan. These entities can be structured to provide support to you in the form of income or principal for beneficiaries while also providing a benefit to the charity (of at least 10 percent of the initial contribution, for CRTs, for example). Charitable trusts can also help with capital gains planning, for instance, when working with a concentrated stock or other large illiquid positions.
Take the Next Step
Proper tax planning can amplify your charitable giving, providing more donation dollars to your cause and potentially increasing the tax benefits to you. Given the complexity of the strategies outlined, be sure to consult with your tax, legal, or financial advisor to discuss how these can be best implemented within your financial life.
As the end of the year draws near, it’s important for you to prioritize proactive tax and financial planning tasks, outside of charitable giving. For more tips and strategies to help you make the right decisions for your situation, be sure to subscribe to our newsletter.