by Joshua (Josh) Machiavello, CPA, Officer
Are you planning to make a charitable contribution before year-end? Consider employing one or more of the following tax planning strategies to maximize your giving and minimize what you pay to Uncle Sam.
Donate Appreciated Securities
Donating stocks instead of cash can be a powerful strategy for giving more while also lowering your tax liability at the same time. Contributions of appreciated, long-term securities (e.g., stocks, bonds, or mutual fund shares) are eligible for a deduction equal to their fair market value. This gives taxpayers the double benefit of both avoiding capital gains tax on any appreciation and taking a charitable deduction at the same time. Consider some examples:
Example 1: Nick’s ordinary income is taxed at a marginal rate of 37%. In 2002, he acquired stock for $100,000 and sold it in 2020 for $150,000. The $50,000 long term capital gain is subject to a combined capital gain and NIIT tax rate of 23.8% (i.e., $11,900). He donated the remaining proceeds ($150,000 – $11,900 = $138,100) to charity which resulted in tax savings of $51,097 (.37 x $138,100). The net result of these transactions is a tax savings of $39,197 ($51,097 – $11,900).
Example 2: Assume the same facts as above, except that Nick instead gifts the stock directly to charity without first selling it. He will avoid paying any tax on the gain. He will also receive a deduction equal to the fair market value of his stock, which results in a tax savings of $55,500 ($150,000 x .37). Donating appreciated securities would save Nick an additional $16,303 of tax compared to donating cash ($55,500 – $39,917).
Be aware that these types of contributions are subject to certain limitations. For example, the charitable deduction cannot exceed 30% of AGI, additional restrictions apply to non-publicly traded securities, and if the securities are held for less than one year then the full fair market value cannot be deducted. Your tax advisor can help you navigate these complexities of the tax code and ensure that your deductions are maximized.
What if your stocks are in a loss position? In that case it makes more sense to first sell the stocks, realize a loss, and then donate the proceeds. This allows you to both recognize a loss on your tax return and take a charitable deduction equal to the amount of cash donated. If the stocks were donated directly, you would never receive any tax benefit from the unrealized losses.
Qualified Charitable Distributions
Are you age 70 and a half or older? Do you own an IRA? If you answered yes to both questions, then you are eligible to make a tax-free distribution of up to $100,000 directly from your IRA to a qualified charity each year. This type of distribution — called a Qualified Charitable Distribution (“QCD”) — can be an easy and effective way to reduce your tax liability.
Taxpayers cannot deduct the contribution as an itemized deduction since the distribution is tax free. However, lowering your adjusted gross income (AGI) can be more beneficial than an itemized deduction. Lowering your AGI potentially decreases the amount of social security income that is taxable, helps to avoid higher Medicare premiums, reduces the extent to which you are subject to phaseouts of certain deductions and credits, and may reduce net investment income tax. If you normally take the standard deduction anyway, then you will still get the benefit of the full standard deduction and lower your AGI at the same time when making a QCD.
It is important to notify your tax preparer whenever you make a QCD from an IRA. The tax reporting forms — called 1099-R’s — do not indicate whether a QCD has been made, and your tax preparer may erroneously report the distributions as taxable income unless you notify them otherwise.
A few cautions: Be sure that the recipient organization is qualified to receive a QCD from your IRA. QCD’s cannot be made to certain charities, such as private foundations, supporting organizations, and donor advised funds. Also, be sure to work with your tax advisor to ensure that a QCD makes sense for you. For example, if you do not have a tax liability in a given year and make a QCD, you won’t realize any benefits. You also will not receive a charitable contribution carryforward since there was no itemized deduction. Your tax advisor can help you navigate through these issues.
Bunching Itemized Deductions
Do you itemize deductions every year? Do you claim the standard deduction every year? If the answer to either of these questions is “yes,” then you may be leaving deductions on the table.
Taxpayers can choose to either “itemize” certain deductions or take a “standard” deduction in lieu of itemizing. The standard deduction is indexed for inflation and for the 2020 tax year it is $12,400 for those with a filing status of either a single or married filing separately. The standard deduction increases to $24,800 for married couples filing jointly and $18,650 for those filing as head of household. Generally, taxpayers will want to choose whichever option yields the largest deduction in a particular year.
Example 3: Rudolph and Clarice are married and file a joint return. In 2020, they made charitable contributions of $15,000 and had other itemized deductions of $8,000. The sum of these itemized deductions is only $23,000. In this scenario, they would want to choose the standard deduction ($24,800 for MFJ) since it affords a larger benefit. Rudolph and Clarice received no tax benefit for their $15,000 charitable contribution in 2020.
Because the standard deduction is so large, many taxpayers realize little or no benefit from their charitable contributions. On the other hand, some taxpayers make very large donations that cause their itemized deductions to exceed the standard deduction. As a result, these taxpayers never benefit from the sizeable standard deduction. However, with proper planning, taxpayers can sometimes realize thousands of dollars in additional deductions by strategically timing their charitable contributions. This tax-saving strategy is called “bunching.”
Bunching contributions for multiple years into a single year allows you to capture as much benefit as possible from both your actual charitable contributions and the standard deduction. In other words, the benefit from actual contributions can be concentrated into a single year — allowing you to maximize the benefit of the standard deduction in the following year(s). Consider again the case of Rudolph and Clarice (Example 3). What if they had adopted the bunching strategy?
Example 4: Same facts as above, except Rudolph and Clarice bunch their annual $15,000 charitable gifts for 2020, 2021, and 2022 into a combined $45,000 donation in 2020. They will not make charitable contributions in 2021 or 2022 and will claim the standard deduction in 2021 and 2022.
As illustrated by the table above, Rudolph and Clarice can increase their combined deductions across these three years by $28,600 through strategically timing their contributions. This strategy can work for taxpayers who generally itemize every year as easily as it can for those who generally take the standard deduction. The key is to concentrate as many itemized deductions into a single year as possible and to maximize the benefit of the standard deduction in years for which no contributions are made.
What if bunching sounds like a great tax strategy, but the recipient charity is accustomed to a certain pattern of support? Utilizing a donor advised fund could be a solution. Contributions to donor advised funds are deductible in the year that you make the contribution to the fund. However, the disbursements from the donor advised fund to a charity can occur in a later year.
‘Tis The Season to Give…Smart
We can help you. These are just a few ways that you can minimize your tax liability. If you are among the millions of Americans contemplating year-end contributions, contact us to discuss these and other strategies.