Many of our clients make regular charitable contributions. The tax laws can be fairly complicated in this area, but there are ways to give more efficiently that are worth knowing if you have charitable inclinations. While these strategies apply to most of our clients, please contact us or an appropriate tax professional before taking action as there may be differences in your individual situation that may limit your deduction, or the appropriateness of a particular strategy. I have also had to omit some details to keep this to a reasonable length and comprehension level. The tax code, as I’m sure you know, is what is known here in the south as a “hot mess.”
Charitable Gifts. First, here are two ways to make charitable gifts with generally better tax outcomes than a traditional cash gift:
- Qualified Charitable Distributions (aka QDCs). If you are over 70½ years old and have an IRA you may redirect some or all of your Required Minimum Distribution (RMD) to a charity (up to $100,000). Note that this must be a public charity (not a private foundation) and it also cannot be a Donor Advised Fund (more on these below). This option is best for taxpayers who have large impacts from a higher AGI (Adjusted Gross Income). For example, taxability of Social Security, itemized deduction phaseouts, personal exemption phaseouts, etc. are all based on AGI. This is a particularly good option for taxpayers who do not itemize or who would not itemize in the absence of charitable contributions. If your IRA has basis (i.e. after-tax contributions) QDCs are considered to use the taxable portion first (this is a good thing).
- Donation of Appreciated Securities (DAS). Frequently the best gift to make to a charity is a donation of appreciated securities that you own in a taxable account (not a retirement account). Suppose 100 shares of stock were acquired many years ago for $5,000 and the value has subsequently grown to $50,000. The position may be transferred to a charity and (with some limitations) a deduction taken for the current value. The charity can sell the securities, and as a non-profit will pay no taxes on the appreciation. The $45,000 gain is never taxed in this case. This is a particularly good strategy if you have a position you would otherwise sell (for diversification perhaps), that has a very low cost basis. It is also nice for positions where you are unsure of your exact cost basis since it never needs to be determined. The example I gave was securities but any property that is long-term capital gain property can work but the rules are very specific so please contact us or another qualified professional in that case. If the taxpayer plans to leave these assets intact to heirs the advantage of gifting these securities is removed as under the current tax code all of the appreciation will be eliminated on inheritance anyway (this is known as a “step-up in basis”).
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 simplified flowchart 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)
Charitable Bequests. Under current law, at death most holdings will be “stepped-up” in value so heirs will have a cost basis equal to the current value. Thus, leaving a bequest of securities as mentioned above doesn’t have an income tax advantage. (In fact, if the estate is not large enough to be taxable, and most estates are not, it would be better to leave the property to an heir and have them make the charitable contribution so that they can have an income tax deduction rather than wasting it by leaving the property to the charity directly.) For bequests, the best gift is generally assets in a retirement account that has only pre-tax contributions. This would include most IRAs, 401(k) plans, etc. To do this, simply name the charity on the beneficiary designation for the account.
Alternatively, to maintain flexibility it is possible to name the charity as a contingent beneficiary and have the primary beneficiaries disclaim the amount they would like to go to charity at that time. Disclaimers are frequently not executed properly, so discussing the plan beforehand and involving competent advisors would be prudent.
The reason these retirement accounts are optimal for charitable bequests is that they generally have no cost basis at all, and as IRD (Income in Respect of a Decedent) property they do not receive a step-up in basis as discussed above. Thus a $50,000 traditional IRA left to someone in the 25% marginal tax bracket would only provide them $37,500 after taxes if they withdrew the funds immediately. Conversely, the entire $50,000 would be available to a charity as a tax-exempt entity. This is an even better strategy than the gift of appreciated securities above because 1) rather than simply a “low” basis, these retirement accounts typically have a cost basis of zero, and 2) the taxes saved are ordinary income taxes rather than the lower capital gains taxes.
Donor Advised Funds (DAF). Sometimes referred to as a “poor man’s foundation” a Donor Advised Fund is a charity and a gift to the DAF is a completed charitable gift that qualifies for a current tax deduction. (Family foundations are generally not recommended unless they will be funded with initial gifts of at least $1,000,000 and there is a reason a simple DAF wouldn’t work to meet the family’s charitable goals.) The DAF account can be invested and the donor, who is no longer technically the owner of the funds, may advise the fund where and when to make contributions, and in what manner (within limits) it should be invested in the meantime. It would be extremely rare for a DAF to disregard the donor’s wishes in regard to gifts to a public charity. DAFs can be opened with as little as $5,000-$10,000 and successor advisors (typically the donor’s spouse or children) may be named as well.
Here are a few specific cases where DAFs can be very useful:
- A taxpayer sells a business or has some other transaction that temporarily raises their income level this year, which puts him/her in a high tax bracket so they want to make a gift to get maximum tax savings, but there isn’t time to figure out what organization would be the best recipient before year end.
- A taxpayer sells a business or has some other transaction that temporarily raises their income level this year, which raises AGI. They want to make significant charitable contributions thus need the high AGI to be able to get the deduction (given the AGI limitations a five-year carry-forward limitation).
- Simplicity/Lack of sophistication of the recipient charities
- A taxpayer wants to give $5,000 each to three very small country churches and wants to use appreciated securities (because their advisor has coached them in previous years that that is the optimal way to do it) but these churches don’t have brokerage accounts, have never accepted stock donations, and are frankly confused by the whole thing. Solution, send $15k of appreciated securities to the DAF, sell the securities and have the DAF send checks to each of the churches. (This is a true story, I was despairing of getting the churches on board when I realized we could just use a DAF.)
- A taxpayer wants to give a large amount to a charity but fears a lump sum would overwhelm them (and be used poorly) and thus uses a DAF to make donations over time while getting the deduction today.
- Post-mortem/Legacy planning
- A family has charitable intent and a taxable estate (over $5,450,000 for an individual – double that for a married couple – in 2016) and prefer leaving funds to charity particularly from an IRA that would be subject to income taxes as well as estate taxes. By naming the DAF as the contingent beneficiary of the IRA, the heirs can use disclaimers to contribute the exact amount the client’s estate is over the estate tax threshold, and the decision doesn’t have to be made until that time. This adds significant flexibility as future estate tax rates, thresholds, and even the family’s finances change over time.
- A family wants giving to continue for many years, and would like younger generations to be able to direct some of those gifts. A DAF with successor advisors can continue the legacy.
- Privacy or Memorials
- A DAF can be named the “Emerson Jones Memorial Fund” or whatever the taxpayer desires.
- A DAF can also be used to preserve the donor’s anonymity. By routing a large gift through a generically named DAF to the eventual recipient charity, no one need know from whom the gift actually originated.
Of necessity, the above discussion has been very superficial. As I noted at the beginning, before implementing these strategies it would be prudent to consult with an appropriate professional for advice and guidance.