By Caleb Alexander and Michael Ganschow
The Tax Cuts and Jobs Act undoubtedly has been felt throughout the country as taxpayers and tax professionals prepare for the many new law changes. A major point of impact for individual taxpayers focuses on the changes to itemized deductions. With the passing of the Tax Cuts and Jobs Act, itemized deductions were drastically reduced, and the standard deduction for all filers nearly doubled. Accordingly, many taxpayers will no longer itemize their deductions and will instead opt for the more favorable standard deduction. Those who continue to itemize will see significant changes to the overall amount of their itemized deductions.
With state and local income tax (which includes property tax) deductions limited at $10,000 and miscellaneous 2% deductions such as investment management fees, unreimbursed employee expenses and tax preparation fees eliminated, charitable contributions will be a driving factor for individuals to be able to itemize going forward. Below we take you through some effective planning tips for charitable giving that can help you maximize the tax benefit of your donations.
Before we dive into planning for your charitable donations, let’s first go over the new rules surrounding charitable donations. Itemizers who make donations from January 1, 2018, through December 31, 2025, can deduct charitable contributions of cash up to 60% of adjusted gross income (AGI) versus the previous 50% limitation. That means if your AGI is $100,000, you can deduct up to $60,000 in cash charitable donations. All other contribution limitations remain in place, and contributions that exceed limitations can be carried forward for a maximum of 5 years.
“Bunching” Itemized Deductions
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.
“Bunching” is a simple method that accomplishes the charitable goal while maximizing the tax benefit of donations. Using the example above, 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.
This method can also be used for property taxes. As previously mentioned, the deduction of state and local taxes has been limited to $10,000. However, if your property taxes are $8,000 each year, you can pay two years’ worth of property taxes every other year. To illustrate this point, in 2018, a married couple could take the standard deduction of $24,000 and in 2019 bunch their charitable donations (assumed total of $20,000) and property taxes (assumed $16,000) for total itemized deductions of $36,000. Had the couple not used the bunching method, they would miss out on the additional $12,000 of deductions.
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!
In summary, the TCJA brings a great deal of change to individuals and uncertainty for many on how these changes will impact their tax returns. With good planning and communication, many tax-advantageous opportunities are out there for individuals to maximize the assets they wish donate to charity while retaining the tax benefit. The above-mentioned methods are by no means a one size fits all and should be discussed with your accountant prior to acting.