Updated January 2020 to reflect the SECURE Act changes
Charitable decisions typically aren’t solely driven by a desire for a tax break. Most of us make philanthropic contributions because there are causes or institutions that are important to us. Still, we all appreciate the deduction at tax time, and at the very least, we don’t expect our taxes or other expenses to increase because we made a contribution. With those goals in mind, here are a few things you can do to ensure you are making your contribution in the most tax-efficient manner.
Understand How the New Tax Law Impacts You – the new tax law has led to a drop in charitable gifts because fewer people see a tax benefit from those donations. There are a few reasons for this. First, for 2019, the standard deduction is $12,400 for individuals and to $24,800 for couples filing jointly. In both cases, the standard deductions are well above their pre-2018 levels. Additionally, if you’re married and filing jointly, each spouse who is 65 or over can take a further deduction of $1,300, while single filers age 65 or older can add $1,650 to their deduction.
At the same time, taxpayers who itemize will find that some deductions have been limited or removed altogether. The most significant change for most taxpayers is the fact that you can no deduct no more than $10,000 for state and local taxes. Note that this includes both property taxes and any income taxes paid, so in areas with higher incomes and home values, many taxpayers are likely to be able to deduct less than they actually pay. Finally, miscellaneous itemized deductions were removed altogether.
The upshot of these changes is that many taxpayers will choose the standard deduction since that will be larger for them than itemized deductions might be. As an example, consider a couple in their early 70s in good health. Since they’re in good health, medical expenses aren’t high enough to deduct. The only other deductions they have are $13,000 in state and local tax and $10,000 in mortgage interest expense. Since the amount they can deduct for state and local tax is $10,000, their total itemized deductions are $20,000, well below the standard deduction of $27,400. Even if they made a charitable contribution of cash of a few thousand dollars, they wouldn’t receive an income tax deduction as the total itemized amount would still be below the amount of the standard deduction. Fortunately, there are a couple of strategies that are likely to be helpful from a tax perspective. They are as follows:
Bunch charitable donations - instead of making donations every year, consider bunching them together in a given year. If, for example, the couple above usually donated $5,000 per year, they could elect to make donations every other year of twice that amount. A $10,000 charitable donation would push total itemized deductions to $30,000, leading to a bit of a tax benefit because total itemized deductions would be higher than the standard deduction.
The strategy of bunching works particularly well when paired with a Donor Advised Fund (DAF). The DAF is essentially a brokerage account you earmark for charitable contributions. You receive the tax write-off when you contribute to the DAF as contributions are irrevocable. However, you don’t have to make immediate contributions from the DAF to a charity - you can elect to invest your contributions and let them grow over time.
You choose when to make contributions from the fund to a recognized charity. This ability to select timing means you could continue your regular schedule of contributions while funding the donor-advised fund with a lump sum contribution that is large enough to net a charitable deduction for you. It’s worth noting that you can’t claim a deduction when you distribute funds from the DAF to the charity, as the deduction is claimed when you contribute to the account. One other tax consideration is that growth and income within the donor-advised fund account are not taxable to you.
Donate appreciated securities- you can donate stocks or bonds to a charity and deduct the full value of the securities at the time the contribution was made. This can be particularly useful if you own highly appreciated securities, and you want to reduce your exposure to those securities. The tax-inefficient way to go about this would be to sell the securities and donate cash. The problem with this approach is that you’ll owe tax on the capital gains from the sale. If, on the other hand, you donate the securities directly to the charity, you get a deduction for the value of the securities, and no capital gains are realized. While the charity will need to sell the securities and realize the gain, charities aren’t subject to capital gain tax, and the realized gain won’t be taxable to them.
Make a Qualified Charitable Distribution from Your IRA – if you’re over the age of 70.5, it is possible to make contributions from your IRA directly to a charity. This strategy can be particularly useful if you are 72 or older and have to take a Required Minimum Distribution from your IRA but don’t need that income.
To understand why this strategy can be attractive, we can return to our hypothetical couple above. Assume that the couple takes their required distribution and then decides to donate $5,000 to a charity. Because their total itemized deductions were $20,000, an additional $5,000 charitable deduction still won’t push them above the standard deduction amount. Thus, they get no tax benefit from the charitable contribution. At the same time, because they took the distribution for themselves and then made a charitable contribution, their adjusted gross income is $5,000 higher than would have been the case had they made a qualified distribution directly to the charity.
While you aren’t taxed on your adjusted gross income - tax is levied based on your taxable income - adjusted gross income is used to determine a variety of tax-related items, from the amount you can deduct for healthcare expenses to property tax to Medicare premiums. A lower adjusted gross income often leads to a more favorably financial outcome on all these fronts, and that is why distributing funds directly from your IRA to a charity makes financial sense. Making these distributions is straightforward, and some custodians make it particularly easy by providing checkbooks for your IRA. If you elect to utilize this strategy, make sure to keep track of your donations as you’re responsible for letting the IRS know which IRA distributions were charitable contributions. Additionally, if you write checks to charities, make sure they clear before the end of the year, or you can find yourself in the position of being penalized for not having taken the required amount from your IRA.
The new tax law has made it more challenging to receive a tax break from charitable contributions. Nevertheless, by using one or a combination of the strategies above and a bit of charitable planning, you’ll increase the likelihood that your philanthropic intentions will provide you a financial benefit as well.