I'm always impressed when clients tell me they want to give away money to people or organizations they don't have to. Practicing altruism makes us feel good about ourselves, helps advance the society we want to live in, and can even boost our egos a bit if we're being honest.
If you've ever donated money for hurricane relief, helped your local Scout troop, supported your alma mater, or tithed at your church, you probably did what most Americans do. You stroked a check.
That's not bad, but there are more advanced strategies that allow investors to fulfill their philanthropic goals as well as net larger tax benefits.
HOW THE BASIC DONATION TAX DEDUCTION WORKS
The size of a charitable donation tax benefit a taxpayer receives is highly dependent on whether or not they take the Standard Deduction on their 1040. There is another set of more complicated donation deduction rules for taxpayers who Itemize. However, in this first section of the post discussing the basic tax benefit, we're going to stick with the standard deduction scenario.
We need to begin with the Consolidated Appropriations Act from earlier this year which extended the charitable deduction mechanics of the CARES Act (2020).
What's nice about both of these Acts is that taxpayers who don't itemize can claim an "above the line" deduction for charitable donations in addition to taking the standard deduction. Prior to the CARES Act last year, it was an either/or decision, meaning, you either itemized to claim a donation deduction or you took the standard deduction and received no tax benefit for donating.
For reference, an above the line deduction is any reduction to gross income before "adjusted gross income" is calculated on the 1040 form. Above the line deductions benefit taxpayers because they effectively reduce a taxpayer's bill without the hassles of itemizing on Schedule A.
For 2021, the tax deduction on charitable donations caps out at $300 per individual and $600 for married filing jointly couples.
It's important to note that the $300/$600 tax deduction for charitable donations represents the maximum amount you CAN deduct from adjusted gross income, not the dollar AMOUNT of the benefit of the deduction itself.
Let's say you donate to 3 different charities in 2021 for a cumulative total of $5,000. Under the current rules, a married filing jointly couple who take the standard deduction is limited to deducting $600 of that $5,000 donation.
Based on that $600 deduction ceiling, a couple in the 22% tax bracket only gets $132 off their tax bill.
Not that inspiring...
We should be thankful that charitably inclined taxpayers taking the standard deduction get something.
However, there are a few charitable strategies that yield a bigger bang for the tax buck.
GIFTS OF APPRECIATED INVESTMENTS
Let's say you bought a stock, mutual fund, or exchange-traded fund (ETF) in a non-retirement investment account years ago and now it's doubled in value. Instead of writing a check to your favorite charity, you should consider donating shares of your appreciated investment instead.
This doesn't mean selling shares and then writing a check from the cash from your brokerage account. You actually elect a transfer of shares without selling.
Here's a hypothetical example of how we do it.
You buy 1,000 shares of ABC Widget & Co. at $1/share. After a year, ABC Widget shares are up 100% and are trading at $2/share. You decide to want to donate all 1,000 ($2,000 worth) of shares to charity*.
We prep a form that you sign and poof, our custodial brokerage (TD Ameritrade Institutional) electronically transfers shares to a brokerage firm owned in the charity's name.
The benefit to you is twofold. First, you avoid the $1,000 of long-term capital gains you would've normally paid if you had sold shares. For most investors, long-term capital gains are taxed at 15%, so $150 in this case.
The second benefit is the basic tax deduction I mentioned earlier in this article. On top of the $150 in long-term capital gains you avoided, you also get to claim up to $300 ($600 for married filing jointly couples). Assuming that 22% federal marginal income bracket, a $600 donation deduction gets you that $132 off your tax bill.
Your total in this example is $282 of tax savings. Compare that to the $132 in savings you would've received had you just sold the stock and then wrote a check.
The trick is identifying positions with the most gains when donating investments. The more long-term capital gains you can "wipe" from your tax slate, the better.
Just imagine donating shares with $20,000 worth of embedded long-term capital gains. You save 15% by donating shares, saving $3,000 that you otherwise would've paid in addition to the $132 you save on the $600 deduction limit!
There are some nuances to all this such as the IRS rules governing the exact share price (fair market value) you get to claim on the date of the charitable donation, but that's a whole other blog post in and of itself.
QUALIFIED CHARITABLE DISTRIBUTIONS (QCDs)
Seasoned investors owning retirement plans must take money out of their accounts starting the year they turn 72 under the New Rules Governing Required Minimum Distributions, aka RMDs.
Folks that are at least age 70.5 are permitted to donate retirement plan assets directly to organizations while simultaneously satisfying their annual RMDs.
Typically, investors who execute this strategy generally tick a few boxes; they don't need the income because there is enough income from other sources, they're charitably inclined, and their annual RMDs tend to be on the larger side, i.e., more than $5,000/year.
The strategy is pretty simple, we instruct our custodian to mail a check directly from a retirement account to the charity. You'll want to save a copy of the account distribution confirmation as well as grab a receipt from the charity for tax purposes, but it's as easy as that.
Here's how the tax magic works. Let's say your RMD is $5,000. The benefit of sending that $5,000 directly to charity is that it's no longer counted as income taxed at ordinary income rates. For most retirees, that's usually either 12% or 22% depending on which federal marginal bracket they fall into. There are also state taxes unless you live in one of the 9 States Without Income Tax.
Colorado residents generally pay a rate of 4.63% on income taxes. For a Colorado investor in the 22% federal marginal income tax bracket executing a $5,000 QCD, they save $1,331.50 on their total tax bill.
There are a few financial planning opportunities here.
First, married filing jointly couples who recognize taxable income under $80,800 pay the wonderful long-term capital rate of 0% (yes, you read that correctly) instead of the typical 15% long-term capital gains rate. A QCD strategy may push a taxpayer below that $80,800 taxable income threshold.
Second, married filing jointly taxpayers with taxable income over $114,600 may be subject to the Alternative Minimum Tax (AMT). QCDs can help push taxpayers below this exemption amount so that tax deductions & credits aren't added back into the tax recalculation.
Similar to the two benefits just mentioned, QCDs can help taxpayers reduce their Modified Adjusted Gross Income (MAGI) below the threshold that triggers Medicare Part B & D premium increases.
In 2021, taxpayers with MAGIs higher than $88,000 ($176,000 for married filing jointly couples) pay an additional $71.70 in monthly Medicare Part B & D premiums on top of $148.50/mo (Part B) plus whatever your Part D premium happens to be (these are plan specific and vary).
Unlike donating appreciated investments, QCDs do not qualify for the tax deduction described at the beginning of this post. The tax benefit comes exclusively from a reduction in Adjusted Gross Income (AGI). However, executing a QCD strategy doesn't require itemizing on your taxes, so that is a win!
If you would like to see if you might benefit from a QCD strategy, here's a flowchart to get you started.
Investors not yet eligible for a QCD strategy have another potential arrow in their tax quiver. In a nutshell, donor-advised funds (DAFs) are companies that allow investors to offload charitable donation steps the investor would normally be responsible for while providing a potentially large tax deduction benefit.
Essentially, an investor with a taxable brokerage account can shift money onto a DAF platform via an irrevocable gift. The investments that transfer to the DAF can still be managed in the same manner as they always were, and the financial advisor associated with the account can still execute their duties of portfolio management.
A key component of the DAF is that the original owner of the investment account is allowed to make requests to the DAF in terms of the timing, scope, and frequency of donations to whatever charities are of interest. The DAF functions as a conduit.
Normally, an investor wouldn't bother with this extra layer of complexity. However, sometimes it can be worth it for the various tax benefits involved with leveraging DAFs.
The biggest benefit is the shift away from taking the standard deduction to itemizing on the tax return. Because the investor makes a single large lump-sum deposit into the DAF, that entire deposit counts as a donation in the year it's made.
This works well for investors who plan on giving to charities each year going forward as part of a bigger picture, long-term gifting philosophy. For example, if you intend to gift $5,000/yr over the next 15 years, a DAF with $75,000 carved out will help to achieve that goal.
Even though the DAF won't be sending all $75,000 out to charity at once, you get to deduct $75,000 worth of charitable contributions all in the year the $75,000 flows into the DAF.
Before we get too excited, we have to remember that gifts of appreciated investments to DAFs are subject to a 30% of AGI limitation. But, assuming the taxpayer meets that criteria, the $75,000 contribution nets the taxpayer $16,500 in tax savings assuming a 22% federal marginal tax bracket.
In order to maximize the deduction, the DAF strategy should be enough to make itemizing worth it versus simply taking the standard deduction. This can get complicated fast, so always double-check with a tax expert who can model your scenario using software before committing.
The other tax benefit of gifting taxable brokerage investments to a DAF is avoidance of the capital gains tax you would've otherwise paid when the investment was sold.
Using the same DAF contribution amount above, let's assume you bought some mutual funds years ago for $50,000 and transfer $75,000 to the DAF. That $25,000 of growth would normally be subject to long-term capital gains rates, usually 15% for most investors.
Avoiding long-term capital gains on $25,000 worth of growth saves you $3,750 in taxes. Add this amount to the $16,500 in savings from the donation deduction and you've saved yourself $20,250 in total taxes.
Like any financial strategy, there are pros and cons. DAF contributions are irrevocable. Once this decision is executed, there's no going back.
In addition, the portfolio inside the DAF could lose value as the market fluctuates. This potentially means that you might not be able to fulfill 100% of the charitable commitments you originally thought you could.
Last, using a DAF means adding another layer of fees to the portfolio. Fees represent a direct drag on portfolio returns, meaning your growth projections might not match up with expectations.
From a financial planning standpoint, thinking strategically about the timing of a DAF contribution can help mitigate taxes. For example, in a year with larger than normal income due to selling a rental house, selling a business, or restructuring a taxable portfolio with sizeable gains, the charitable tax deduction can help bring the overall tax bill down.
The way this works is due to the "bunching" nature of deductions associated with a DAF contribution. One year's worth of $5,000 charitable tax deduction isn't going to make a huge dent in the tax bill, but combining 10, 15, or even 20 years' worth of future deductions into a single year absolutely can!
All three strategies described in this post reflect some sort of enhanced tax benefit that will likely yield more tax savings than the simple charitable tax deduction when a taxpayer donates cash.
Each strategy has nuance and complexity beyond what I mentioned above. Working with an experienced financial planner or tax advisor who takes the time to understand your situation is key to maximizing the tax benefit as well as avoiding surprises. Although many of my posts discuss DIY topics, this is not one of them.
If you'd like our advice specific to your situation or have general questions, please reach out. The "Contact" link at the top of the page is a great place to start!
* Note that there are limited benefits for donating appreciated investments held less than 1 year.