By Ginny Graef, CPA, Tax Senior Manager and Mike Gracik, CPA, Director | Family, Executive & Entrepreneur Advisory Services
Leverage Charitable Giving to Reduce Your Tax Liability
As 2020 draws to a close, taxpayers should consider using charitable giving in order to reduce their taxable income for 2020. For many individual taxpayers, the use of charitable contribution planning may be one of the few discretionary planning methods left to help reduce their tax liability.
Bunching Charitable Contribution into One Tax Year
Beginning with tax year 2018, the Tax Cuts and Jobs Act (TCJA) roughly doubled the standard deduction for all taxpayers (for joint filers in 2020 the deduction is 24,800 dollars). This change, coupled with the 10,000 dollar deduction limit for state and local taxes, means many more taxpayers will find they are no longer itemizing, but rather claiming the standard deduction. It is estimated that for 2020 only 15 percent of taxpayers will itemize, whereas before TCJA the percentage of itemizers was about 31 percent.
With the increase in the standard deduction, one strategy to maximize the tax benefits from charitable giving is to pay two, three or even several years’ worth of contributions in one tax year, so that your itemized deductions in that tax year exceed the amount of the standard deduction. In the years that follow, you would not make any charitable contributions but again claim the standard deduction.
Establish a Donor Advised Fund
Many taxpayers may not be comfortable with the above bunching strategy because they do not like the idea of paying more than one year’s worth of contributions to charity at one time. In addition, taxpayers’ philanthropic interests often change from year to year.
If this is the case, to accomplish the bunching strategy, taxpayers should consider setting up and contributing to a donor advised fund (DAF). A DAF is a fund sponsored by a public charity that allows donors to make one (often sizable) contribution to the DAF, receive a current year tax deduction for the contribution, and then recommend grants from the DAF to their favorite charities over time, often many years.
DAFs are an especially efficient tax planning vehicle when there is a year in which you have unexpectedly high earnings and even more so when that income is considered ordinary and taxed in the highest tax brackets
There is a stacking rule built into our current tax code which means that itemized deductions first shelter ordinary income items such as interest income and wages, and then second they offset qualified dividends and long term capital gains. With proper planning, a taxpayer could potentially offset all ordinary income items and just pay tax on their qualified dividends and long term capital gains at the current 0 percent, 15 percent and 20 percent federal tax rates.
Give Appreciated Long Term Securities
Whether or not you give directly to the charity or to a DAF, keep in mind one of the most tax efficient methods for making a charitable contribution is to make the contribution using long term appreciated securities. Stock market values are at all-time highs, and as a result, 2020 could be great year to make contributions using appreciated securities.
If the security has been held for more than 12 months, a taxpayer that makes a charitable contribution using appreciated securities receives a tax deduction for the FULL fair market value of the security and does not have to pay income tax on the built in appreciation contained in the security. Keep in mind the deduction for contributions of appreciated securities is limited to 30 percent of adjusted gross income (AGI), while contributions of cash have higher AGI limits. For donations of appreciated securities made to a private foundation, the donation is limited to 20 percent of your AGI. If your donation exceeds the AGI limits, the excess charitable deduction can be carried forward for up to five years.
CARES Act Increases Contribution Deduction Limits
The CARES Act was passed by Congress in March 2020 to combat the negative economic impact of the Coronavirus. This bill contained several taxpayer friendly changes to the tax code, with two in particular designed to encourage taxpayers to make charitable contributions in 2020.
First, and for 2020 only, the AGI limit for CASH contributions was increased to 100 percent of AGI from 60 percent. This new limit applies only to cash contributions and not to contributions of appreciated securities. In addition, it is important to note that cash contributions to DAFs do not qualify for the increased limits.
To take advantage of this higher AGI limit, taxpayers should consider not only making their annual charitable contributions in 2020, but also pre-paying future contributions in 2020 so as to use this new AGI limit to shelter a large part of 2020 taxable income.
Taxpayers who are considering converting their traditional IRA to a ROTH IRA in 2020, could shelter up to 100 percent of the additional taxable income arising from the conversion. While the 60 percent limit would still be applicable, in this situation, a donor advised fund could be especially helpful as it would provide a vehicle to hold the large contribution until you are ready to allocate the funds to the charity or charities of your choice.
Second, for taxpayers that plan to claim the standard deduction in 2020, the CARES Act allows an “above the line” deduction of up to 300 dollars for cash contributions made in 2020. This 300 dollar limit applies to both single and joint taxpayers.
Make a Qualified Charitable Distribution from your IRA
With the increase in the standard deduction amounts discussed earlier, Qualified Charitable Distributions (QCDs) from IRA accounts have become an even more important tool for qualifying individuals to manage their charitable contributions.
A QCD is an otherwise taxable distribution from an IRA owned by an individual that is over the age of 70 ½ that is instead directed to a qualified charity. The amount directed to the charity is not taxable income to the individual. Taxpayers over 70 ½ can make QCDs of up to 100,000 dollars per tax year. QCDs also reduce the amount of the Required Minimum Distribution (RMD) in a given tax year.
For qualifying individuals, making a qualified distribution allows those who are now taking the standard deduction to still reap a direct tax savings by giving to charity. It should be noted that QCDs cannot be used to make contributions to DAFs.
It should be mentioned that the CARES Act discussed earlier and the SECURE Act (enacted as of January 1, 2020) both contained provisions that have provided additional tax planning strategies as it relates to the use of QCDs.
First, the SECURE Act increased the age at which taxpayers must take their RMD from their IRA from age 70 ½ to age 72 (for those taxpayers that had not reached age 70 ½ by December 31, 2019).
Second, the CARES Act suspended all RMD requirements for all taxpayers for tax year 2020.
However, neither the CARES Act nor the SECURES Act changed the age at which taxpayers can make QCDs from their IRA accounts. Individuals must still be 70 ½ years of age before they can utilize the QCD.
Even though RMDs have been suspended for 2020, qualifying taxpayers may still want to make use of the QCDs for 2020. Making a QCD in 2020 will have the effect of reducing the IRA account balance as of December 31, 2020, which will in turn reduce the RMD amount required for 2021.
QCDs can also be a source of income to aid in the implementation of the contribution bunching strategy discussed above.
For many individuals who are already making annual QCDs, the distributions often do not add up to the 100,000 dollar annual limit. With the suspension of RMDs for 2020 under the CARES Act, those individuals may not want to make any contributions for 2020. Instead those taxpayers could make QCD contributions for both 2020 and 2021 in tax year 2021. Doubling up on two years (or more) in 2021 could have a big impact on reducing the amount of the RMD required for 2022. Keep in mind that the 100,000 dollar limit is an annual limit and any unused amount cannot be carried forward to a future year.
Final Thoughts Contributions in 2020 vs 2021
During the 2020 Presidential campaign, there was much discussion about President-Elect Biden’s plan to increase tax rates for those individuals with taxable incomes over 400,000 dollars. Many taxpayers may have considered postponing contributions to 2021 in order to shelter income that could be taxed at a higher rate in 2021.
While this strategy could have some merit, it should be noted that tax rates for taxpayers with income over 400,000 dollars are still fairly high, with the top bracket reaching 37 percent. As a result, taking into account the time value of money, it might still make sense to go ahead and make the contributions in 2020. This is especially the case if the amount and type (ordinary vs qualified rates) of taxable income for 2020 is expected to be higher than 2021.
Additional Tax Planning Resources
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.