Kevin Michels, CFP®, EA
Charitable donations are one of the most popular tax deductions taken on a tax return. Not only are you helping others in need, but you receive a nice tax benefit as well that "recoups" a portion of the donation.
For retirees and those transitioning into retirement, careful planning can maximize the tax deduction on their donation because a lack of planning could leave thousands of dollars on the table or result in no additional tax benefit at all!
Mechanics of Receiving a Charitable Tax Deduction
The deduction for a charitable donation is taken on Schedule A of Form 1040. Schedule A is where you itemize certain deductible expenses. If these itemized deductions are less than the standard deduction, you take the standard deduction ($25,100 for Married Filing Jointly and $12,550 for Single). If your itemized deductions are larger than the standard deduction, you deduct the total of those itemizations from your income.
The most common expenses you can itemize are:
- Medical expenses (anything above 7.5% of your adjusted gross income)
- State and local income and real estate taxes (capped at $10,000)
- Mortgage interest
- Charitable donations
Your itemized or standard deduction is subtracted from your adjusted gross income to arrive at your taxable income. Your tax rate will be applied to your taxable income to determine your tax liability.
For example, if you file Married Filing Jointly and have $100,000 of adjusted gross income and $30,000 of itemized deductions, your taxable income is $70,000. About $20,000 will be taxed at a 10% rate, and the remaining $50,000 will be taxed at a 12% rate (your marginal rate). Your tax liability would be about $8,000.
Charitable Deduction Roadblocks
You should be aware of a few roadblocks and opportunities when making a charitable donation if you want it to maximize the deduction on your return.
- Do you take the standard deduction? If so, you receive no tax benefit for making a charitable donation . "Bunching" your donations together in one year could increase your itemized deductions above the standard deduction.
- Will your tax rate drop soon? If so, "bunching" your donations together in a year where your tax rate is high can result in a larger tax deduction (for example, the last few years before you retire)?
- Can you receive a double tax benefit on your charitable donation by donating highly appreciated investments instead of cash? In many cases, you can avoid capital gains tax by donating assets instead of cash.
Using a Donor Advised Fund (DAF) to Make Charitable Donations
If you answered "yes" to any of the three questions above, a Donor Advised Fund (DAF) may be able to help maximize your charitable tax deduction.
A DAF is a private charitable giving account created by you to manage charitable donations.
Think of your DAF as a holding account for your charitable donations. You fund it with cash or other appreciated assets, like stocks, mutual funds, real estate, etc. As the trustee of the DAF, you have complete control and discretion over the funds inside the DAF. You decide which charities to donate to, when, and how much they receive.
One of the best parts of using a DAF, and the focus of this blog post, is the ability to "uncouple" the timing of your tax deduction from when you actually donate to a charity.
With a DAF, you receive your tax deduction when you fund the account, not when you donate to a charity.
For example, if you typically donate $1,000 each year to the Boys and Girls Club of America, you could put $10,000 in your DAF today, and then each year for the next ten years, send $1,000 from the DAF to the Boys and Girls Club of America.
In this scenario, you'd receive a $10,000 deduction on your current year taxes (based on your donation to the DAF) and no deduction in future years when you send money out of the DAF to the Boys and Girls Club of America.
The ability to "uncouple" the timing of your tax deduction from your charitable donation allows you more flexibility in controlling your deduction when it comes to charitable giving. Using a DAF, we can address the three scenarios presented above to maximize your tax deduction.
"Bunching" Donations to Increase your Itemized Deductions Above the Standard Deduction
If you donate to charity and you take the standard deduction, you receive no actual tax benefit from your charitable donation. Whether you donate or not, you still get the standard deduction. For example:
Charles and Rosa's itemized deductions include $10,000 in state and local taxes and $10,000 in charitable donations for a total of $20,000, which is less than the standard deduction of $25,100.
Charles and Rosa's charitable donation has no effect on their tax deductions because even if they didn't make the charitable donation, they'd still receive the standard deduction.
Of course, this shouldn't disincentivize them from donating to a charity, but it is a bummer! A possible solution to this problem would be to "bunch" together multiple years' worth of charitable donations into a DAF to increase the itemized deductions past the standard deduction for the current year and then donate the funds from the DAF to a charity at their discretion over time. Using the same example above:
Charles and Rosa plan on making $10,000 annual donations to their church over the next five years. To maximize their tax deduction, they fund a DAF with $50,000 in the current year. Each year for the next five years, they will send $10,000 from the DAF to their church.
Their current year tax return will show itemized deductions of $60,000. $50,000 for their charitable donation + $10,000 in state and local taxes.
Their itemized deductions are now $34,900 higher than the standard deduction ($60k - $25,100), saving them $7,678 in tax liability this year (assuming a 22% marginal tax rate). Each year going forward, they'll take the standard deduction just as they would have already.
"Bunching" Donations to Receive a Deduction at A Higher Tax Rate
Another opportunity to increase your charitable tax deduction is to "bunch" your charitable donations in a year when you're in a higher tax bracket than you will be in the future. For example:
Jake and Amy will be retiring at the end of this year. They're in the 24% marginal tax bracket and expect to drop to 12% in retirement.
Knowing their deduction is more valuable at a 24% rate rather than a 12% rate, they "bunch" 10 years' worth of charitable donations, $100,000, into a DAF. They plan on distributing $10,000 from the DAF each year for the next ten years to their favorite charities.
As a result, they receive a $24,000 tax deduction on their charitable donations using a DAF ($100,000 x 24%) compared to just a $12,000 deduction ($100,000 x 12%) without one.
Double Tax Benefit: Avoid Capital Gains Tax & Still Get Your Charitable Donation
The last way you can use a DAF to increase your tax deduction is by making donations using appreciated assets such as stocks, bonds, mutual funds, real estate, etc.
When you donate an appreciated asset to a DAF, you don't have to pay tax on the unrealized gain, and you still receive your charitable deduction as long as you itemize. For example:
Raymond and Patrice have a sizeable taxable brokerage account. One of their positions is $50,000 of Apple stock with a basis of $5,000, resulting in a $45,000 unrealized capital gain. If they were to sell that stock today, they would pay $6,000 in federal income tax ($45,000 x 15%).
Instead of making their charitable donations with cash, they donate their entire Apple stock position to their DAF. Each year for the next five years, they sell $10,000 of Apple stock in the DAF and send a check to their favorite charity.
This results in a charitable tax deduction of $50,000 from donating the Apple stock to the DAF, and Raymond and Patrice never pay a cent in capital gains tax on the sale of their Apple stock.
If Raymond and Patrice are still bullish on Apple stock, they could take the $5,000 of cash from their bank account that they would have otherwise used to make the charitable donation and invest it back into Apple stock each year. This allows them to still maintain their position in Apple without the high unrealized gain.
DAFs are an effective way to manage your charitable giving. You maintain complete control and have the opportunity to maximize your charitable tax deduction. In conjunction with careful planning, DAFs can lead to thousands in tax savings and allow you to keep more money in your investment accounts to grow over time.
Keep in mind there are limits to how much you can deduct as a charitable gift each year. If you're donating cash, it's limited to 30% of your adjusted gross income; if you're donating appreciated stock, it's limited to 60% of your adjusted gross income. However, you can carry forward unused deductions for up to 5 years.
If you're 72 and take the standard deduction, you can also use a Qualified Charitable Distribution to ensure you get a tax deduction on your charitable donations.
To learn more about using a DAF feel free to reserve some time on one of our advisor's schedules by clicking here.
1 The CARES Act temporarily allows taxpayers to take a $300 tax deduction for charitable donations even if they take the standard deduction.