You may have heard of the strategy of “bunching” charitable contributions. This is a tax optimization strategy for folks who are charitably inclined, but who might not itemize other than that (or even despite that). Obviously, the new tax law makes the strategy applicable to a much larger number of people. For example, suppose someone is MFJ with no mortgage. Other than their $10k of SALT (State And Local Taxes) they may well have no itemized deductions other than whatever charitable gifts they make – and if those gifts are less than $14k each year (plus inflation to the $24k standard deduction limit, but I’m going to keep this simple and just use a limit of $24k) they will get no tax deduction for them. Suppose they regularly donate $10k/year to their place of worship – would it make sense (perhaps using a DAF as a holding vehicle) to donate $20k every second year (getting a $6k deduction)? $30k every third year (getting a $16k deduction)?
I was curious how many years should be bunched. I think it is a function of the following:
- How much the taxpayer “normally” gives.
- Their marginal tax bracket.
- Their discount rate (they must come up with more cash initially to do the strategy).
- How far they are from itemizing (if they would itemize even without the charitable contribution they needn’t – and shouldn’t – bunch).
Here is a spreadsheet which shows the NPV of the strategy for various levels of bunching and discount rates.
Yellow cells are the inputs. Discount rates are after-tax so think munis, not t-bills, for rates.
Using my previous example, with a 30% marginal tax bracket, and a 5% discount rate (which I think might be high), the taxpayer should do charitable contributions 8 years ($80k) at a time.
Other considerations and issues:
- Less wealthy charitably-inclined clients tend (I think) to look at it in terms of dollars/year, as in, “I give (or want to give) $X/year to Y charity.” More wealthy clients may think of donations of large lump sums periodically. This calculator is more applicable to the less wealthy.
- There is of course uncertainty as to future tax rates which is virtually impossible to handicap, but I think the risk goes both ways. Marginal rates could go up, marginal rates (not taxes maybe, but rates) could go down (perhaps in conjunction with a VAT for example). A few years ago who would have predicted the lower tax rates that now exist?! (English really needs an interrobang.) Of course the client’s situation can vary too so this is very similar to figure out whether and how much of a Roth conversion to do.
- I’m not sure at this point what discount rate is “right” but it is an interesting question. Let me generalize a little bit which may make it clearer. I think it might be easier to think about an expense other than charitable giving. A client can prepay an expense. The expense is not large relative to their net worth. For example, a gym membership where you can pay annually (less) or monthly (cumulatively more). What is the cost of capital that should be used to figure out whether to do it or not? I can think of four possibilities plus four possible adjustments/other factors.
- Hurdle Rates:
- The return on their checking or savings account because they now carry a lower balance.
- The return on a short-term bond fund because it is short-term “investment.”
- The HELOC rate because they now carry a higher balance.
- The expected return on their portfolio – i.e. what their 60/40 is expected to do. I don’t think this is right because the risk is different, but it is a possibility and would be analogous to the WACC for a company I suppose.
- Adjustments/Other Factors:
- Convenience – I might prefer to pay the gym annually rather than monthly to simplify my checkbook balancing or avoid potential late fees if I forget (online banking may have made this issue largely moot).
- Optionality – I might prefer not to pay the gym annually because I might change my mind or want to go to a different gym. On the other hand, in this specific example, I might want to incent myself to go – it’s the sunk cost fallacy, but it seems to work for many folks. So the optionality value could conceivable be negative.
- Risk – I might prefer not to pay the gym annually because I might get injured, move, etc. so it could be wasted.
- Forced saving – I might prefer my checking/savings balance look lower, so I don’t spend the money on other consumption or unwise purchases. Or discourage spouse from same.
The calculation – here is the intuition behind the spreadsheet:
- We want the present value of the difference between donating $X every year vs. doing it in lumps when we are $D distance from itemizing. For ease of calculation let’s assume someone is:
- $10k from itemizing (e.g. $14k of non-charitable deductions for MFJ)
- they would normally give $15k/year
- we want to know the value of bunching 5 years
- with a discount rate of 5%
- and a marginal tax bracket of 24%
- In year one the incremental value is:
- An outflow of $60k (four extra years at $15k each)
- An inflow due to the incremental tax deduction of $14,400 ($60k*24%)
- So the net cash flow in year one is an outflow of $45,600
- In the subsequent years (4 in this case) the value is:
- An “inflow” (really just less expense) of the $15k they aren’t donating
- An “outflow” of $1,200 (the $5k they would have been over the standard deduction at a 24% tax rate)
- So the net cash flow in subsequent years is an inflow of $13,800 (again it’s really a lower expense, but that is the same as an inflow to the household)
- The PV of a payment of $13,800 for four years at 5% is $48,934 [=PV(0.05,4,13800) in Excel]
- $48,934 minus $45,600 is $3,334. I.e. the present value of bunching in this case is $3,334.
A related question is whether a taxpayer should use a Qualified Charitable Distribution (QCD) vs. Donation of Appreciated Securities (DAS). Assuming the taxpayer has the choice of either (i.e. they are over 70½ and have securities with long-term capital gains) here is my analysis of the optimal choice:
- Does the taxpayer itemize?
- No, not even with the prospective DAS → QCD
- Yes, or only with the prospective DAS → go to next question
- Is the taxpayer’s LTCG rate greater than 0% (including through a future step-up)?
- No → QCD
- Yes → go to next question
- Is the taxpayer subject to SS or other phaseouts?
- No → DAS
- Yes → uncertain (you have to run the numbers)