I love paying taxes.
No, really, I do!
Of course, it's not the act of paying taxes that I adore, it's the fact that, generally speaking, if you're paying a lot in taxes, it's because you made a lot of money!
That being said, that doesn't mean I want to pay, nor do I want my clients to pay, any more in taxes than we are legally obligated. So, what can be done?
If you're giving any amount of money to charity on a regular basis, the odds are good that you're missing some opportunities to reduce your tax bill in the process (thus, increasing your ability to donate). Here are three opportunities you may be missing out on.
Qualified Charitable Distributions (QCDs)
If you are over the age of 70.5 and you have money inside of an IRA, you should probably be doing most, if not all, of your charitable giving via a QCD. Here are the basics:
- A Qualified Charitable Distribution is a payment from your IRA directly to the charity of your choice (The charity must be eligible to receive tax-deductible charitable contributions. You can search the IRS's website here to see whether an organization qualifies.).
- The money must go directly from your IRA to the charity; it can't pass through your bank account first.
- You must be at least 70.5 years old.
- You can donate up to $100,000/year.
- You don't get a deduction for the QCD, but you also don't have to add it to your income.
- You can use it to offset or entirely satisfy your Required Minimum Distribution (RMD) for the year.
The primary benefit of the QCD is that it doesn't matter whether you have enough other, non-charitable federal tax deductions to be able to receive a tax benefit for your donations. Consider the following example:
George and Louise are both 75 years old. They regularly make a $20,000 donation to their local United Way. Their deluxe apartment in the sky is paid off and they have state and local taxes in excess of $10,000 each year. They have no other federal tax deductions beside their charitable donations and their state and local taxes. If they write a check to the United Way they will have a total of $30,000 in itemized deductions between that and their state and local tax deduction. However, even if they didn't have any state and local taxes or charitable deductions, they would still be able to take the standard deduction and avoid paying taxes on $24,800 of income! Therefore, their $20,000 donation only reduced their taxable income by $5,200 ($30,000-$24,800)! If they are in the 24% federal tax bracket, then they would have saved about $1,248 in taxes.
However, George and Louise also have a $50,000 required minimum distribution that they have to take from their IRAs. Their very wise financial advisor recommended that, instead of writing a check to the United Way this year, they take a qualified charitable distribution. Now, George and Louise don't have to pay taxes on any of that $20,000 and they still get to take the standard deduction of $24,800, thus saving them about $4,800 in taxes; almost 4 times greater tax savings than if they had just written a check! *
Donating Appreciated Assets
This is, in my experience, the most underutilized tactic of the three we're looking at today. Here are the basics:
- You can choose an asset that you own, most commonly publicly trades securities, and gift that ownership to a charity.
- When you do this, you can usually receive a charitable deduction for the "fair market value" (FMV) of the asset for up to 30% of your adjusted gross income (AGI) from that year. (The rules around how much of a deduction you can take for what types of property can make your head spin, so make sure to consult a qualified tax professional when contemplating these types of gifts.)
- In addition to the charitable deduction, you also won't have to pay taxes on any unrealized capital gain (the difference between what you bought it for and what it is worth) you might have in the asset.
- The charity can then liquidate the asset that you donate and use the proceeds to fund their operations.
Here is an example to illustrate the benefits of this strategy:
Beyoncé is a high earning professional who also likes to give back to her community. Every year, she donates $40,000 to her local food bank. She is able to itemize her deductions since she maxes out the cap on state and local income taxes at $10,000 and she has more than enough mortgage interest to easily exceed the $12,400 standard deduction for a single lady. For simplicity's sake, let's assume she is in the 24% federal tax bracket and the 15% long term capital gains bracket.
She usually writes a check to the food bank, but this year her tax advisor told her that she should donate some of the stock that she has in a taxable brokerage account instead. She has shares in one publicly traded stock that she has owned for more than a year. The shares are worth $40,000, but she only paid $10,000 for them. If she sells the shares and then donates the proceeds, she'll have to pay $4,500 in capital gains taxes ($30,000 capital gain X 15% capital gains tax rate), but if she just donates the stock directly to the food bank, she can forego that $4,500 tax while still getting to take the charitable deduction for her $40,000 donation. Thus, the "cost" of her $40,000 gift to charity is only $25,900 ($40,000 gift - $4,500 capital gains tax savings - $9,600 federal income tax savings)! *
This process can get much more complicated if you are donating something more complex than publicly traded securities, such as ownership in a closely held private business, real estate, art, etc. It can also be a challenge if you are trying to do this with a smaller non-profit that doesn't have the infrastructure set up to receive something as simple as publicly trades securities, let alone something more complex, or if you are trying to do this across multiple charities you support. However, one potential solution to both of those problems is item number 3 on my list...
Donor Advised Funds (DAFs)
You may be familiar with this term as these types of accounts have grown tremendously in popularity in recent years, in part because of the Tax Cuts and Jobs Act that was passed into law in 2017. Here are the basics:
- A DAF is a giving vehicle established and administered by a public charity.
- You can donate cash, publicly trades securities, and other assets to a DAF and receive a tax deduction the way you would if you donated those assets directly to a traditional non-profit.
- Once the money is in the DAF, you no longer have any ownership claim on any of those assets. However, you can name yourself as the advisor of the fund and the sponsoring organization will almost always accept your recommendations on how to distribute the funds in your DAF.
- DAFs can be especially useful if you want to make multiple donations to different charities from the proceeds of the sale of one asset. That is particularly true if the asset in question is one that your preferred charities are not equipped to handle, such as a donation of mineral rights or S-Corporation stock.
- DAFs can also be useful for folks who want to engage in "charitable clumping," a strategy I'll discuss in the example below:
Let's take a look at an example of how a DAF can be used to minimize and simplify one's taxes:
Mork and Mindy write checks for $2,000 every year to 5 different charities (for a total of $10,000 in charitable donations). Because they have no other deductions besides their state and local income taxes (capped at $10,000), they typically take the standard deduction of $24,800.
Mork & Mindy's financial advisor suggests that, since they have the means to do so, they could contribute 5 years of charitable donations all at once to a donor advised fund, and they could do so with appreciated publicly traded securities. This would allow them to save on capital gains taxes the same way that Beyoncé did in the example above but with only 1 transaction instead of 5 separate transactions every year for 5 years, and it would also allow them to take advantage of "charitable clumping," as described in the next paragraph.
Let's assume Mork and Mindy are in the 24% tax bracket. If they give $10,000 to charity every year for the next 5 years, they will never have enough deductions to itemize and they will take the standard deduction every year. If, instead, they donate $50,000 to a DAF in year 1 (and then use that DAF to distribute $2,000 to each of their 5 favorite charities every year for 5 years), they will have $60,000 in itemized deductions. That amount exceeds the standard deduction amount by $35,200, which means they will see tax savings of $8,448 ($35,200 excess itemized deductions X 24% tax bracket). Nanu, nanu! *
Putting It All Together
- Qualified Charitable Distributions out of an IRA for those older than 70.5 are a great way to save money on taxes by circumventing the need to itemize deductions.
- Donations of appreciated assets are a great way to avoid having to pay capital gains taxes while still earning a charitable deduction.
- Donor Advised Funds are a great tool for simplifying the tax planning portion of your giving while potentially aiding in strategies such as "charitable clumping."
The information provided here is for general information only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. Past performance is no guarantee of future results.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Gateway Wealth Management, LLC does not provide tax advice.
*This is a hypothetical example based on U.S. federal tax laws as of 11/01/2020. Your results may vary.