Jim Montague, Senior Trust Officer
The US Tax Code is so long that no one’s sure just how long it is, with an incredibly complex system of deductions and refunds that savvy accountants take advantage of. One of the items that you should be considering when you take stock of your finances before tax season is charitable deductions. Charitable deductions, in addition to being a great use of your accumulated wealth, will help reduce your tax bill.
Getting a Complete Picture of Your Finances
Whether you’re looking toward estate planning or simply thinking about the taxes you’ll owe in April, you can’t make a reasonable plan for how much money you can give to charity if you haven’t taken stock of what you have.
That’s why we recommend assessing your financial situation at least every three years. Every year, we see clients who are doing well for themselves — they have no qualms about paying their mortgage, buying a new car, or taking a vacation — but they don’t have a complete picture of their assets and opportunities. Before you can start making significant decisions about charitable giving, you should take stock of your own situation.
The Earlier You Can Start, the Better
The difference between estate planning and year-to-year tax planning is that the latter carries a hard deadline — if you’re looking forward to submitting your 2020 taxes in April 2021, you have until exactly December 31 to make the charitable donations you want to make.
Of course, you can write a check for $10,000 and drop it off at the front desk of a local charity office on December 31. You’ll still be able to take the full $10,000 tax deduction on your taxes for that year, and the charity will get their money.
But you might be missing out on other financial opportunities by waiting until the last second. For example, you could be funding that donation with appreciated securities that you’d otherwise have to sell and realize capital gains upon, thus saving yourself on taxes twice over.
Or you could set up a donor-advised fund (more on DAFs below) and put $500,000 in the fund. You take the entire $500,000 deduction this year, but you can set up the fund to donate $10,000 a year for the next 50 years.
These other options take time to set up, however. If philanthropy is a significant pillar of your financial plan for the year (or going forward), there’s no time like the present to get started.
Recent Changes to the Tax Code
In 2017, the Tax Cuts and Jobs Act was passed, bringing about significant changes to the American tax code. If you’ve been making the same filing decisions your whole life, it’s worth re-examining the way that deductions are handled under the new rule.
The first change to note is that the standard deduction rose by nearly 100 percent to $12,200 for individuals and $24,400 for married couples filing jointly. As a result, middle-class families are now less likely to itemize their deductions. If your income is high enough that your deductions will exceed these amounts, this aspect of the law won’t affect you.
Bunching Your Deductions
For people who are on the fence about whether they should itemize their deductions are not, there’s a technique called “bunching.” It requires careful timing and planning of the items you intend to deduct, but it can save you thousands if executed correctly. Here’s an example:
Imagine you and your spouse own a home outright, with no mortgage. You pay $12,000 per year in property taxes, and you generally give about $10,000 per year to a local charity. Given that the deduction on your property tax is capped at $10,000, your total deduction is $20,000 from these two sources. The standard deduction is $24,400, so it makes more sense not to itemize in this case.
“Bunching” your deductions would mean donating two years’ worth of contributions ($20,000) in one year, bringing your deduction to $30,000 and saving you money over the standard deduction. If you bunch your donations every few years and take the standard deduction in the interim, you can save a substantial amount on your tax bill.
Incentives to Give More
Besides, the new tax bill raises the deduction limit from 50 percent of your AGI (adjusted gross income) to 60 percent, so you can deduct an even more significant portion of your income and reap the tax benefits.
Consider Donations Other Than Cash
If you have a diverse portfolio, it’s worth thinking about donating long-term appreciated securities, real estate, S-corp or C-corp stock, or other investments. When you donate long-term appreciated assets to a charity instead of selling them and donating the proceeds, you avoid paying capital gains tax (up to 20 percent) and the 3.8 percent Medicare surcharge.
Here’s an example, assuming the donor is in the top income tax bracket of 37 percent. Let’s say you paid $30,000 for stocks that are now worth $100,000. If you sell those stocks, you’ll get $100,000 in cash, but you’ll owe $16,660 in taxes on the $70,000 in profit that you made. That only leaves you with $83,340 to donate, in addition to a higher tax bill.
If you donate those stocks directly, you’ll pay no capital gains tax and no Medicare surcharge. Your total contribution will be the full $100,000, and the higher tax deduction will save you on your final tax bill.
Combine Cash and Securities
Donating securities helps reduce the amount of capital gains tax you’ll have to pay, but your deduction is capped at 30 percent of your AGI. In years where you’d benefit from an even larger deduction, you should consider supplementing your donation with cash. Deductions from cash are limited to 60 percent of your AGI, so a combination of the two can give you a higher contribution and lower bill than either one alone.
Consider a Donor-Advised Fund
A donor-advised fund (DAF) is a great way to reduce your tax bill while simultaneously maximizing your charitable giving, especially after you retire and your income drops. Here’s how it works:
- You make a contribution of assets to the DAF. These can be cash, stocks, real estate, retirement account assets, or other properties. This contribution is irrevocable and is now owned by the DAF.
- You immediately receive the maximum tax deduction as allowed by the IRS. If you put money in the DAF on December 31, 2019, you’ll qualify for the deduction on April 15, 2020.
- You name advisors, successors, and beneficiaries to the fund. These people will manage the money in it and take over control after you die. Your fund managers and advisors can invest the money elsewhere, allowing it to grow tax-free.
- At any point, you can recommend that money or assets from your DAF be granted to various charities.
The benefit of this system is that you can make donations now, while your income is high enough that you can afford it, and take substantial tax deductions at the same time. The DAF will continue to grow during your peak earning years. When you retire and can no longer afford to give such a large portion of your income to charity, you’ll still have the contents of the fund, so you can continue your charitable ways long after your income decreases.
Talk to a Financial Advisor
Everyone’s financial situation is different, from your income to your goals to the portfolio of assets you have to your name. At First Western Trust Bank, we pride ourselves on tailoring a financial plan that’s as unique as you are, using our 12-point ConnectView® system.
We’re not tax advisors, and the information in the article above shouldn’t be construed as official tax advice. Rather, our goal is to make sure you’re as informed as possible about your options when it comes to managing your money. If you’re wondering how to reduce your tax bill while maximizing the amount of good you can do in the world, give us a call! We’ll take a look at your assets and goals and help you create the plan that’s right for you.