Strategic Tax Decisions Before You Make Charitable Donations

Now that we are heading into fall, where the overwhelming majority of donations are made to charities, it’s a great time to strategically think about “how” you are going to donate.

As requests for donations come in the mail, many of us feverishly write out checks to our charities and non-profit organizations of choice, and of course, our alma mater.

Before you write out that first check, take a moment to consider two important strategies. The first is available to anyone who has appreciated investments held outside of IRAs.

The second is only available once you have reached age 70 ½.

Let’s begin with the first potential strategy which is available to everyone regardless of age.

Strategy #1: Donating Shares vs. Cash

As we have discussed on many occasions, any gain realized when selling shares of an investment held outside of IRAs is subject to capital gains taxes.

However, when you donate shares of these appreciated investments, as opposed to donating cash, you can avoid these capital gains and potentially make a bigger charitable donation.

Essentially, you can sell shares of an appreciated investment, pay the capital gains tax, and then donate the proceeds to charity, or you can donate the shares directly to the charity prior to selling them.

Let’s walk through a quick illustrative example of someone in the 32% federal tax bracket making a $10,000 donation.

Sell Your Shares and Donate the Proceeds

Let’s assume the investment you purchased years ago for $4,000 is now worth $10,000. If you sold it, $6,000 would be subject to capital gains tax.

At a combined federal and state capital gains tax rate of 25%, you would owe $1,500 in taxes, thus netting you out at $8,500 after taxes.

Assuming you then donated the $8,500 proceeds to charity, the charity would receive $8,500, and your federal income tax savings on your donation would be $2,720 (32% bracket).

Donate Your Shares Instead

As an alternative, if you donated the full market value of your shares to charity directly, $10,000, your tax savings on your donation would be $3,200 (32% tax bracket), and your charity would receive $10,000 instead of $8,500.

The key component of this is your charity of choice does not pay capital gains tax when they sell your shares because charities don’t pay taxes.

Mechanics

The mechanics of this are actually quite simple. You have two options:

1 – Ask your charity of choice for their gifting instructions for donating securities (Account custodian, Account number, DTC number, etc.). All sizable charitable organizations have brokerage accounts which receive charitable donations of shares of stock or mutual/exchange traded funds.

Provide these written instructions to your account custodian, i.e. Charles Schwab, Fidelity, etc., and designate the company and lot of shares you wish to donate.

You would then receive a receipt indicating the fair market value of the donated shares to use for income tax return preparation.

2 – The second option, is to donate these appreciated shares to a charitable or donor-advised fund. Once you donate your appreciated shares to this separately designated fund, you qualify for the charitable deduction.

From there, the charitable fund sells your appreciated investment shares and you instruct the charitable fund custodian (Schwab, Fidelity, etc.) to make your desired donations. The account custodian sends a check directly to your charity(s) of choice.

The importance of this method is two-fold:

• First, it simplifies the process because you only have to donate shares to one fund instead of multiple charities.
• The second key component is it allows you to donate amounts larger than you are planning to donate in a given year, qualify for the larger itemized deduction, and then make donations on your timetable. This is very important because of the larger $15,750 standard deduction most Americans have ($31,500 for those filing jointly) and $17,750/$34,700 for those over age 65 respectively, thus potentially eliminating the added tax benefits of making charitable donations because you already qualify for the higher deduction without the charitable donation.

Strategy #2: Qualified Charitable Distributions

If you have charitable intentions and you have reached age 70 ½, take a close look at Qualified Charitable Distributions (QCD), i.e. making donations directly from your IRA!

There are two important tax concepts at work to clarify here:

1 – RMD and QCD: Once you reach age 73 (formerly age 70 ½), the IRS mandates that you withdraw a certain amount from your IRA each year and pay income taxes on the amount withdrawn.

As with Strategy #1, where most Americans donate cash or write a check to a charity after they have paid capital gains in order to free up the cash, many also do so after paying taxes on their IRA Required Minimum Distribution.

With a Qualified Charitable Distribution (QCD), you may make charitable donations directly from your IRA to the charity of your choice once you have reached age 70 ½ thus bypassing the multiple step transaction of making your required IRA withdrawal, paying income taxes, making a charitable contribution with the net amount, and then claiming the donation as a tax-deductible contribution.

** After the Secure Act bills were passed and the Required Minimum Distribution age for IRAs was increased to age 73, the age requirement for QCDs remained at age 70 ½.

2 – Itemized vs. Standard Deduction: If you already make charitable donations, what makes the QCD strategy so important is the change in tax law regarding itemized vs. standard deductions which doubled the standard deduction as I shared above.

Couple this with other itemized deduction limits and phase-outs for state and property taxes, and it’s more and more likely that you will be using the standard deduction because your itemized deductions may not exceed that $31,500 limit.

While this is generally good news because filing is much simpler, it may mean that your charitable donations offer you no greater tax benefits because donations are itemized deductions.

The potential benefit of the QCD in this case is you may still receive the tax saving benefits from a charitable contribution even though you file using a standard deduction.

For example, if your itemized deductions, which include your charitable donations, total $31,500, you would file using the standard deduction and your charitable donations would not have provided any additional tax benefits.

However, if you donate funds directly from your IRA to the charity, you are able to receive a tax break even if you file using the standard deduction.

The mechanics of this are quite simple. You simply provide the custodian of your IRA (i.e. Schwab, Fidelity, etc.) with the name of the charity and the amount you wish to donate, sign the appropriate form, and the custodian withdraws funds from your IRA and sends a check to you payable to the charity for you to share with them.

If your IRA Required Minimum Distribution for the year was $50,000, and you made a Qualified Charitable Distribution of $5,000 from your IRA, you would only pay income taxes on $45,000 instead of $50,000.

Intentional and Strategic

The key with each of these strategies is to always be intentional and strategic with everything you do financially, even making charitable donations.

While making charitable donations is a very noble thing to do, taking a few minutes to explore your options not only has the potential to increase your tax benefits, but the organization you donate to receives may receive additional benefits as well.

This is intended for informational purposes only and does not constitute personalized tax, legal, or financial advice. The strategies discussed are hypothetical and may not be suitable for every individual or situation. Before making any charitable donations or implementing tax-related decisions, readers should consult with their qualified tax advisor and financial professional to evaluate what is appropriate for their unique circumstances.