Many taxpayers around the country have given to charity for years and the tax deduction associated with those donations was an added bonus. However, with the sweeping new tax law changes that took effect in January 2018, some taxpayers may no longer receive a tax benefit for donations. The new standard deduction is $24,000 for married couples filing jointly and $12,000 for single taxpayers. Additionally, the total deduction allowed for real estate and state and local taxes is capped at $10,000, so the deduction for charitable donations may not be large enough for many taxpayers to exceed the standard deduction. However, with careful planning, there are ways you can maximize the tax benefit of your charitable donations.
One tax planning strategy is using a donor-advised fund (or DAF) for your charitable donations. First, what is a donor-advised fund? The basic concept is that it’s an investment account, managed by a non-profit, which is typically a charitable organization under the umbrella of a financial services firm. The account is tax sheltered because it is considered a 501(c)(3) public charity. We view it like a “charitable checking account.”
Establishing an account is straight-forward and a matter of signing the paperwork from the provider. There are some things to keep in mind, such as the cost of opening the account, any ongoing fees charged for managing and administering the account, as well as account minimums. You also want to ensure that the charity of your choice is an eligible recipient of any gifts you choose to make.
When assets are contributed to the DAF, the donor is eligible for a charitable deduction at the time of contribution. The deduction amount is generally the fair market value of the assets donated, with certain limitations based on Adjusted Gross Income. The assets then grow tax-free in the account. Investment choices may be limited to a short list of investment options, but could be as flexible as a brokerage account. Regardless of how it is invested, the funds can typically be donated to the charities of your choice over time.
When a gift is made from the DAF, the grant must go to a charity in good standing with the IRS. It cannot go to individuals, nor can it be granted to charitable remainder trusts, charitable lead trusts or private non-operating foundations. It also cannot be used to satisfy a charitable pledge.
To illustrate a simple example of how someone may use a donor-advised fund, assume Mr. and Mrs. Client normally donate $5,000 per year to various charities. Further assume they have state and local taxes of $5,000 and property taxes of $10,000. In the past, this would have given them $20,000 of Schedule A deductions. However, under the new law, which limits their deduction for state and local and real estate taxes to $10,000, they effectively no longer receive a tax benefit for their charitable donations since the standard deduction of $24,000 is higher than their allowable deductions.
However, assume they decide to make a donation of $20,000 in one tax year to a donor-advised fund. For tax purposes, they are eligible for a $20,000 charitable deduction. As noted above, their itemized deductions in the past fall just short of the standard deduction of $24,000. But, by using this strategy, they would have itemized deductions of $10,000 for state and local tax and property taxes, and $20,000 for charitable donations, for a grand total of $30,000. In subsequent years, they would benefit from the higher standard deduction of $24,000 while still making annual distributions of $5,000 to charity from their DAF. By front loading the gift, or “bunching”, your donations into a donor-advised fund, you have control over your itemized deductions from year to year and maximize your tax deductions.
There are several reasons to consider using a donor-advised fund. For example, assume your income is higher in a particular year than it would normally be, due to a large bonus, or retirement. You could “prefund” future donations now and get a tax deduction while your current tax rate is higher. Perhaps you are exercising stock options; you could combine that with a large donation to your donor-advised fund to help reduce your taxable income that year. You might also want to donate highly appreciated stock to a DAF, rather than selling them, thereby avoiding recognition of the gains. By making larger donations in a particular year, families can also create a legacy to teach younger generations about gifting.
We understand and support the fact that people are going to continue giving to their charities because they are charitably inclined and not doing it solely for the tax benefits. However, if there are few tax planning tips that can be utilized, why not use them? Even though some deductions are limited by the new tax law, with careful planning, there are still some creative ways to help lower your tax liability.