As you grow your income and financial assets, you’ll inevitably grow your tax bill too. It’s a byproduct of building wealth. How you feel about taxes might depend on your political leanings. However, if you’re like everyone I’ve met, you don’t want to pay more than you have to. If you are charitably inclined, knowing how to maximize charitable deductions is crucial for effective tax planning.
If there’s a cause or community you like to support, charitable giving is one of the best ways to reduce your taxes while doing good! Not all methods of giving benefit you equally, however. It’s not only about the value of the gift. Other factors such as the timing of the gift, what you are giving (cash vs. non-cash, for example), and what type of charity all factor in. Even other parts of your financial situation can determine how much of the gift you actually get to deduct. Let’s get started with some of the ways you can reduce your tax liability through charitable deductions.
Charitable Deductions Only Count When You Itemize
In order to benefit from your gifts, your itemized deductions have first to add up to more than the standard deduction. In 2022 that amount is $25,900 for married taxpayers filing jointly. You are able to deduct the greater of itemized deductions or the standard deduction. You don’t get both.
Itemized deductions are the total of:
- unreimbursed medical expenses
- qualified long-term care premiums
- home mortgage interest
- sometimes home equity line of credit interest
- state and local taxes
- charitable contributions
- casualty and theft losses
- unreimbursed job-related expenses
- certain miscellaneous deductions.
Let’s say you make a $5,000 cash gift to your favorite charity, and your other itemized deductions add up to $20,000. Your $25,000 of itemized deductions are less than the standard deduction, so your gift doesn’t result in a deduction. While you can feel great about supporting the charity, you will receive the standard deduction of $25,900 just as you would have if you had not made the gift. Fortunately, a strategy might help you here.
Bunch Itemized Expenses to Receive Greater Charitable Deductions
Assuming you want to keep supporting this charity on an ongoing basis, you could make your gift every other year. This would mean skipping a year of making the gift and doubling up on the gift the following year or vice versa.
Taking the scenario above, if you instead gave $10,000 to charity, your itemized deductions would total $30,000, which is greater than the standard deduction by $4,100. If your taxable rate is 25%, that would mean savings of $1,025! The following year you would not make a gift and receive the standard deduction. You would then repeat this pattern as long as you want.
Charitable Contributions to a Donor Advised Fund
While you now know how to bunch contributions to maximize deductions, you might not feel great about skipping years of giving. If we’re talking about a huge charity, it might not matter very much. If we’re talking about a smaller, local charity, the irregular cash flow might be harder to manage for them.
This is where a Donor Advised Fund (DAF) comes into play. DAFs are financial accounts and are like charities themselves, so you get credit for a contribution in the year it is deposited. Money can accumulate inside the DAF and be dispersed to your chosen charities in the form of a grants when you give instruction. Most DAFs will allow you to invest your contribution like other investment accounts until you decide which charity gets a grant, how much they get, and when they get it.
This means your gift of $10,000 can be dispersed to your charity over two years, allowing a $5,000 grant to be made annually. The charity gets predictable cash flow. You maximize your charitable deductions because you contributed $10,000 in one year and cleared the standard deduction!
There are other benefits to DAFs as well, but combining them with a bunching strategy is one of the most useful.
Charitable Deductions from Gifting Investments
Giving away shares of a security (stock, ETF, mutual fund, etc.) that have increased in value is an effective strategy and should be used instead of donating cash if you hold these investments in taxable accounts. In taxable investment accounts, you are taxed when you sell a security for more than your basis, which simply means what you paid for it. You pay $5,000 for shares (your basis), and years later they are worth $10,000. Selling at $10,000 results in a taxable gain of $5,000.
By giving away shares to a charity, you get credit for the value of the gift without selling. No sale. No tax. The charity can sell the shares and avoid tax as well. Why should you do this instead of giving cash if you like your investment? You’d give shares with a lower basis while buying more shares with your cash. This would result in a higher basis for the new shares which would decrease your tax bill when you sell in the future.
This only makes sense when shares of the security have increased in value. If your shares are worth less than what you paid for them, you’d be better off selling them and booking a loss (which offsets other income) and giving away the proceeds instead.
Gifting securities is also a useful strategy if you hold shares of an investment you no longer want. I often use this method with clients who transfer in higher cost or less tax efficient taxable investments from other firms. We can get rid of an existing investment over time without paying taxes on the gain. We are then able to replenish their account with cash to buy shares of something else.
To initiate a gift of shares, contact the charity and let them know you want to transfer shares. Many charities already have brokerage accounts in place to receive these transfers. If they don’t, it’s a simple process for them to open one. Most DAFs can accept transfers of shares as well. So don’t forget about combining this strategy with bunching to increase charitable deductions.
Qualified Charitable Distributions
Qualified Charitable Distributions (QCDs) are only an option if you’re over age 70 ½. They aren’t technically a charitable deduction in the same way we discussed deductions above, but they still result in a lower taxable income for the taxpayer. As a result, they are often the best way to give to charity while in retirement for taxpayers with IRAs.
Once you reach age 72 you are forced to take distributions from your IRAs each year or face significant penalties. These are Required Minimum Distributions (RMDs) which increase your taxable income. Alternatively, you can donate all or a portion of your RMD to charities through QCDs up to $100,000 annually.
QCDs satisfy the RMD requirement, but the amount of the distribution won’t appear in your income at all! This strategy provides a way around the standard deduction situation discussed previously. Less taxable income in retirement can also mean lower Medicare premiums and more favorable taxation of Social Security benefits, so it’s worth considering as your retirement charitable giving strategy.
In order to accomplish this, you should contact your advisor or custodian and have them send the funds directly to the charity. If you request a normal distribution and then donate, it won’t work. You’d be right back dealing with the standard deduction.
QCDs are more restrictive on the kinds of organizations that can receive them. The organization must be a 501(c)(3), so check on the organization’s eligibility before moving forward. DAFs, for example, cannot receive a QCD.
Limitations on Charitable Deductions
While this won’t apply to many people, those making larger gifts should be aware of limits on charitable deductions. The amount you are able to deduct with some of these strategies is linked to your income, the type of charity receiving the gift, and whether or not the gift is cash or other property. Contact your tax professional or use the IRS website for guidance.
Need help evaluating your charitable giving strategy? Schedule a free consultation or email us.