Charitable contributions are an excellent way to support your favorite charities and support your community. However, the tax laws include various restrictions regarding charitable contribution deductibility, which can create a confusing landscape for potential givers. For instance, charitable contributions must be made to a qualified charitable organization, and they must be appropriately substantiated. This article will help to simplify these rules for charitable contributions.
What is a Charitable Contribution Deduction?
The charitable contribution deduction has been a part of the U.S. tax code for over 100 years and has remained a valuable resource for taxpayers to reduce their taxable income. Charitable contributions are reported on Schedule A (Itemized Deductions) of an individual’s Form 1040 (Individual Income Tax Return). Tax laws are constantly changing, but the charitable contribution deduction has remained consistent over the years. The majority of changes to the charitable contribution deduction have involved the total amount that a taxpayer can deduct, but there have recently been additional changes due to COVID-19. It is important to stay aware of these modifications in order to maximize the deduction on an income tax return.
What is a Qualified Charitable Organization?
In order for taxpayers to deduct charitable contributions, gifts must be made to a qualified organization and not for the benefit of a specific individual.
A qualified charitable organization is an organization that pursues interests in the public good and not its own profit interest.
Such organizations can apply for and be granted tax-exempt status by the IRS under Internal Revenue Code Section 501©(3), and are then eligible to receive tax-deductible charitable contributions. The following are a few examples of organizations that qualify:
- most nonprofit organizations such as American Red Cross and Goodwill
- nonprofit hospitals
- educational organizations
- nonprofit organizations that service public parks and recreational areas
- community foundations
- private foundations
- charitable trusts
Taxpayers can ask any organization whether or not it is a qualified organization, and they should be able to inform the taxpayer accordingly. The IRS’s online search tool, Exempt Organizations (EO) Select Check, can help you more easily find out whether an organization is eligible to receive tax-deductible charitable contributions. You can access EO Select Check at https://www.irs.gov/charities-non-profits/exempt-organizations-select-check. Information about organizations eligible to receive deductible contributions is updated monthly.
What is Qualified Charitable Distributions (QCD)?
Qualified Charitable Distributions (QCD) is another useful tool for satisfying charitable giving. A QCD is a direct transfer of funds from your IRA custodian, payable to a qualified charity. QCDs can be counted toward satisfying required minimum distributions (RMDs) for the tax year, while excluding the amount donated from the taxpayer’s taxable income. Since the income is excluded from taxable income, taxpayers may not also deduct the charitable donation, but the direct donation still has the effect of reducing taxable income and the tax impact of RMDs.
Requirements for Charitable Tax Benefits
The tax benefits of charitable contributions vary based on the taxpayer’s individual situation. Depending on the type of contributions made, the IRS has placed some limitations on the amounts that can be claimed as a deduction on a return.
Outright gifts of cash (which include donations made via check, credit card and payroll deduction) are the easiest. The substantiation requirements depend on the gift’s value:
- Gifts under $250 can be supported by a canceled check, credit card receipt or written communication from the charity.
- Gifts of $250 or more must be substantiated by the charity.
For donations under the adjusted gross income (AGI) limits, the reduction in tax liability will depend on the giver’s tax bracket. The taxpayer must itemize deductions on Schedule A and may be subject to overall Schedule A deduction limits that have been put in place for higher income taxpayers.
- The total, deductible cash contributions a taxpayer can make in any given year cannot exceed 60% of the taxpayer’s AGI for the year or 30% if made to a private non-operating foundation (with some exceptions).
- There are 30% and 20% deduction limitations for contributions of non-cash appreciated property, depending on the type of charitable organization.
- If the donation amounts exceed these deduction thresholds, the excess deduction can be carried over to future tax returns for five years.
- Donations to qualified charities generally are fully deductible for regular tax and AMT (alternative minimum tax) purposes and can also help high net worth taxpayers reduce their estate tax exposure.
Charitable contribution deductions are allowed for AMT purposes, but your tax savings may be less if you’re subject to the AMT. For example, if you’re in the 37% tax bracket for regular income tax purposes but the 28% tax bracket for AMT purposes, your deduction may be worth only 28% instead of 37%. In addition, other tax benefits can be realized by the many different forms of charitable giving, including donated appreciated assets thereby saving the capital gains taxes on those assets.
What does not qualify as a deductible charitable donation?
Examples of donations that would not be tax deductible include:
- political/lobbying organizations
- foreign charities
It is also important to note that when a charity provides something of value to a donor in exchange for the donation, only the amount of the donation in excess of the goods or services provided is deductible.
Cash contributions that are not tax deductible include those:
- Made to a supporting organization
- Intended to help establish or maintain a donor advised fund
- Carried forward from prior years
- Made to most private foundations
- Made to charitable remainder trusts
These exceptions also apply if you itemize your deductions.
For example, if Matt buys a ticket to a charity dinner for $150 and the value of the dinner is $25, Matt can only take a charitable deduction of $125. Donations of $250 or more must be recognized with a receipt from the charitable organization, and if a good or service is provided, the receipt should have information to determine the amount of the tax-deductible gift.
How to Save Money on Your Taxes with Bunching
“Bunching,” also called “bundling,” is a simple method that accomplishes the charitable goal while maximizing the tax benefit of donations. It is timing charitable giving to produce maximum benefit for the taxpayer.
With the TCJA (2017), the standard deduction nearly doubled to $24,000 (married couple) and $12,000 (single person) resulting in more taxpayers claiming the standard deduction. One of the implications of claiming the standard deduction is the taxpayer does not benefit by itemizing deductions for his or her charitable giving. Through “bunching,” individuals can condense two or more years’ worth of charitable giving into a single tax year and itemize to gain the maximum tax benefit, then take the standard deduction during other years.
Individuals often make donations to the same organization year after year or make specific donation commitments over a specified period. For example, an individual might give $10,000 per year over 20 years to their church or make a commitment to donate $30,000 over three years to a fundraising campaign at their alma mater. With other deductions being limited or eliminated in 2018, that $10,000 donation each year may no longer push that individual over the standard deduction. Using “bunching” the taxpayer would donate $20,000 every other year instead of $10,000 yearly. The concept would simply be applied across the board for the taxpayer’s donations, so that every other year the doubled donations would help to exceed the standard deduction.
If “bunching” sounds like a beneficial planning technique, you might want to consider setting up a Donor Advised Fund (DAF). Utilizing a DAF, donors can contribute assets into their named account, get an immediate tax deduction, invest, and grow DAF assets tax-free, then suggest grants out of the fund to support the charities of their choosing over time. “Bunching” and DAFs require additional tax planning with a tax professional but can be very useful tools for maximizing the charitable contribution deduction.
Donor Advised Funds (DAF)
Donors may worry that bunching can cause financial stress for organizations to which they donate. For example, an organization may heavily rely on steady donations to survive month to month or year to year. A donor may be concerned that the organization will spend all the funds in year one rather than allocate them over two years. A donor-advised fund (DAF) can provide a solution to that budgeting challenge.
A DAF can offer the flexibility to relieve the effect bunching can have on donations while allowing the donor to spread contribution amounts over time. A DAF is a charitable giving vehicle that allows an individual, family or corporation to make an irrevocable tax-deductible contribution and at any time after the contribution recommend what qualified charities will receive donations and when.
While contributions to a DAF are deductible at the time the donation is made to the fund, the funds do not have to immediately be distributed to the recommended charities. Thus, a year in which you decide to bunch donations of $20,000 in cash, you have the control to ensure the DAF only distributes $10,000 in year one and then distributes the remaining $10,000 in year two.
DAF’s are offered by various organizations, including community foundations and brokerage firms such as Fidelity, Schwab and Vanguard, and essentially act as a charitable investment account. Typically, to setup a DAF, a minimum initial donation must be made, but a minimum account balance is not required to be maintained after the initial donation. Administrative fees are charged to cover costs such as processing transactions and providing donor support.
Once the contribution has been made to the donor-advised fund, the gift is complete and binding. For estate tax purposes, the day the asset was contributed, it is no longer considered a portion of your personal assets, and thus is not part of your taxable estate.
Before funding a DAF that you intend to use distributions from to satisfy charitable pledges or commitments (or before using distributions from an existing DAF to satisfy charitable pledges or commitments), discuss your plans with your tax advisor to be sure that what you want to do complies with current tax law.
Donating Appreciated Long-Term Assets
Cash may not always be the best asset to donate to charity. Appreciated assets, such as stock or even real estate, can be a more tax advantageous asset to gift. Appreciated assets can be gifted directly to the charitable organization and can be made through a DAF as well. An example here is qualified appreciated stock purchased 20 years ago for $1 per share and is now worth $200 per share. If you sell the stock and donate the proceeds, you will end up with a taxable capital gain. If you donate the stock directly, no capital gain is recognized, and the FMV of the stock on the date of the gift is the amount you can deduct. Note that to receive this favorable treatment and have the charitable deduction based on FMV, the assets must be held longer than one year. On the flip side of this, you will not want to donate qualified appreciated stock that has lost value. In that circumstance, it is more advantageous to sell the shares and then donate the proceeds so that you may recognize the loss on the sale and get a charitable donation as well.
Donating RMD’s from Individual Retirement Accounts
Taxpayers who have contributed money over the years to a traditional retirement account such as an IRA are required to take annual withdrawals known as Required Minimum Distributions (RMDs) after age 70 ½. With an account such as an IRA, the contributions to the account were pre-tax contributions going in; therefore, the distributions out of the IRA are included in taxable income and taxed when received. However, there are tax advantaged giving opportunities when it comes to RMDs.
For taxpayers who have multiple streams of retirement income and do not particularly need the RMDs to live on during retirement, they can use the annual RMD from an IRA up to $100,000 as a tax-free qualified charitable distribution. They can choose to donate the entire amount of the RMD for the year, or it can be broken up and a portion be donated while receiving the remainder to live on. The key with making a tax-free qualified charitable distribution using your RMD is to set up a direct transfer from the IRA to an eligible charity so that the money is never distributed directly to you. If the distribution is received by the taxpayer and then donated, this will not qualify as a tax-free qualified charitable distribution.
It is important to note that you do not need to itemize to take advantage of a tax-free qualified charitable distribution. Since the RMD will be going directly to a charity rather than you, the income is not recognized on your tax return and thus no tax is owed on this distribution. Furthermore, since the distribution would not be included in taxable income, no charitable deduction is received as an itemized deduction. This means that for those taxpayers who are not itemizing and are taking the new larger standard deduction, the exclusion of the income from their return is the equivalent of a dollar-for-dollar charitable deduction without any reduction to their standard deduction – the best of both worlds!
Charitable Donations FAQs
When is the best time to make charitable contributions?
Charitable deductions are one of the most flexible tax planning tools because you can control the timing to best fit your needs. You may be wondering when you should make your charitable contributions: before the end of the year or after New Year’s Day? There are many items to consider when making this decision.
What tax rate will your deduction be saving you this year vs. next year?
To determine this, you will want to understand what your taxable income will consist of for the years in question. Does one year consist mostly of long-term capital gains or qualified dividends that are taxed at a lower rate than wages, SE income or retirement plan distributions? Additionally, what tax bracket are you expecting to be in? If you’ve had high-income this year that will push you into the top tax bracket but expect only to be in one of the lower brackets next year, then it’s better to take that deduction now and offset your high tax.
The charitable contribution deduction is a vital part of the U.S. tax code benefiting both individuals and charitable organizations for decades. If you have questions regarding the charitable contribution deduction and maximizing its benefit, please reach out to LBMC.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.