Guess what? The IRS (and thus Congress, the government, and Americans) wants you to give to charity. They know (like you should) that you will come out behind financially for doing so, but they want to lessen the financial pain a bit to encourage you to do more for humanity and the planet. Here are the seven tax breaks the IRS provides for charitable givers.
# 1 Charitable Deduction
This is the one that most people know about. If you write a check to charity, you can take the amount of that check as an itemized deduction on Schedule A. Of course, if you take the standard deduction [far more likely starting in 2018 with the new, higher standard deduction ($12,400 and $24,800 married for 2020) and the limit on the SALT deduction,] that donation isn’t going to reduce your taxes one lick. But if you do itemize, and you have at least $12,400/$24,800 of other itemized deductions such as taxes and mortgage interest, then the charitable donation should be completely deductible. So if your marginal tax rate is 42%, and you donate $10,000, that should reduce your tax bill by $4,200. Note that paying $10,000 to reduce your taxes by $4,200 is not a winning strategy. But if you’re going to give the money anyway, it’s nice to be able to do it with pre-tax dollars. This helps you have $4,200 to spend somewhere else, or thought of another way, give an extra $4,200 to charity that you would not have been able to give otherwise.
In addition to cash, you can also donate stuff. If it is stuff that you don’t really use, it’s like free money. You do have to keep careful records of what is donated, to which charity (it can’t be your brother in law), and on what date. This has a great side effect of decluttering your house. It usually works better than a garage sale too. Rather than selling 1/4 of the stuff you want to get rid of for 10% of its value, you get to dump all of that junk for 30-40% of its value, more than you’ll usually get at a garage sale anyway. Plus you don’t have to spend your Saturday sitting in the driveway.
But wait, there’s more. If you serve in a charity, you can deduct all of the expenses associated with your service. For example, if you drive the scouts to scout camp four hours away, you might be able to deduct 500 miles worth of travel at 14 cents per mile for a deduction of $70 ($29 off your tax bill if your marginal rate is 42%.) Granted, that’s not even going to cover the gas, but it’s better than a kick in the teeth. Unfortunately, you cannot deduct the cost (i.e. opportunity cost) of your time. Nor can you deduct the value of charity care delivered in your office.
I’ve taken this deduction every year since at least residency, except 2018 when I bunched my deductions into 2017 and took the standard deduction for 2018.
# 2 Waived Capital Gains
This is a fun one that I do from time to time. Instead of giving cash to the charity, why not give them appreciated mutual fund shares from your taxable account? Not only do you get your usual charitable deduction, but neither you nor the charity has to pay the long-term capital gains taxes. Be sure you’ve owned the shares at least one year. If you combine this tactic with tax loss harvesting and smart fund selection, you can invest VERY tax-efficiently in a taxable account.
# 3 Donor Advised Fund
This option is popular among finance bloggers. They like saving money on their taxes and they like investing. Like a 401(k), with a Donor Advised Fund (DAF) you get to do both. Of course, you don’t get to do any spending, but finance bloggers don’t like that anyway. They prefer knowing they can spend to actually spending. With a DAF, they get to know they can give without actually giving. That’s because you get the tax break (and start getting tax free growth on the investments) when you put the money into the account, not when the charity actually gets the money. In fact, you can get the tax break and then leave the money in the account for decades without making any charitable distributions if you like. Kind of a jerk move, but I don’t make the rules. The other downside of a DAF is that there is usually another layer of fees. Even at low-cost mutual fund giant Vanguard, that’s a substantial cost of 0.60% per year on the first $500K in the account.
So why do people (who aren’t jerks) actually use a DAF? Well, three main reasons. The first is simply that a tax break now might be much more useful than a tax break later. This is Physician on FIRE’s excuse for
being a jerk front-loading his DAF in preparation for future giving. He is in his peak earnings years now (actually as of 2019 retired from medicine at 43) and then plans to have a dramatically lower taxable income for years and years afterward while taking the standard deduction and wants to make sure he gets the tax break so he can give as much as possible to his favorite charities. Lots of others used a DAF at the end of 2017 to take advantage of the changes in tax brackets and the standard deduction going into 2018.
The second reason, and one of the two reasons why I’m probably going to be using a DAF in 2019 despite the fact that PoF and his readers are never going to let me forget about it, is for convenience. Although a DAF doesn’t really work for tiny deductions (Vanguard has a $500 minimum for a gift from the DAF to a charity), it’s a whole lot easier to keep track of one big donation to a DAF than dozens of smaller donations throughout the year or even over the years. It is also pretty darn convenient for Vanguard, the charity, and you to gift appreciated shares to the DAF and then distribute cash to the charity instead of going through the rigamarole of donating appreciated shares directly.
The third reason is anonymity. With a DAF, you still get to control what charity gets the money (by “advising” the fund manager to make distributions.) But the best part is that the charity doesn’t get to know who sent them the money. Some people really like that because it makes the contribution feel more “pure” to them. I like it because it prevents my mailbox from being filled with “charity porn.” Not only is it annoying and planet-destroying to have to transfer all that paper from my mailbox to my trash can, but it means more of the money I donated is going toward marketing and fundraising rather than the charitable cause I’m trying to support! If you immediately distribute money from the DAF, not only do you get to avoid “pulling a jerk move” but you also avoid paying that additional layer of fees for long, all while getting the twin benefits of convenience and anonymity.
# 4 Qualified Charitable Distributions
A Qualified Charitable Distribution (QCD) is actually my favorite way to donate money to charity. Unfortunately, I can’t do it because I’m too young; you have to be 70 1/2 to do it. This is when, instead of taking a Required Minimum Distribution (RMD) from your IRA or 401(k), you instead have the IRA provider send all or part of the distribution to your favorite charity. This fulfills the RMD requirement (and prevents that nasty 50% penalty for not taking an RMD) and makes it so you don’t have to pay taxes on the RMD. A QCD essentially allows a retiree to take the standard deduction and still get a deduction for the charitable contribution. I predict they will become more and more popular as people realize the effects of the new higher standard deduction on the value of itemizing. I helped my parents do this in 2018 and 2019 and I couldn’t believe how easy it was. At Vanguard, you simply go into the RMD screen, choose “sell the fund”, choose “send me a check”, type in the name of the charity, and hit enter. Then Vanguard sends you the check and you can forward it on to the charity. Be sure the check is in the charity’s name, not yours. The only way Vanguard could make this easier would be to send the check directly to the charity. (Hint, hint Vanguard.)
# 5 Private Charitable Foundation
This is like the rich man’s DAF. DAFs generally have relatively low minimum initial and ongoing contribution limits. Those limits at Vanguard are actually relatively high at $25,000 and $5,000 respectively compared to other DAFs. At those sorts of amounts, a private charitable foundation doesn’t make much sense. But at larger amounts, the benefits of a Private Charitable Foundation start outweighing the additional expense and hassle.
There are two types of private foundations. An operating foundation operates the charity itself. A non-operating foundation makes donations to various charities, as the Bill and Melinda Gates Foundation does. Either way, the foundation has a board of directors who determine how it is run and is subject to stringent IRS rules.
The big benefits of a foundation over a DAF are that it can employ your children (or you) as members of the board, it can accept a wider variety of assets (like a family owned business), and it can give money to organizations and people that are not IRS-qualified public charities.
The big downsides are the much larger administrative hassle, a 1-2% excise tax on earnings, less anonymity, and a potentially more limited tax deduction. The deduction for a DAF donation is limited to 60% of AGI for cash donations and 30% for appreciated assets. For a private foundation, those numbers are 30% and 20% respectively.
Most doctors aren’t going to be forming a private charitable foundation, but it can make sense for some entrepreneurs, especially at the time of sale of their business.
# 6 Charitable Lead Trust
There are two types of trusts worth discussing here. The first is a charitable lead trust. With this, you donate money (or appreciated assets) to an irrevocable trust. The trust then makes payments to a charity for a period of time (such as the rest of your life) and upon your death, the remaining assets in the trust are distributed to your heirs. You can tweak the numbers around a bit, but the general rule is that the more that goes to the charity, the larger your initial deduction. Note that unlike a DAF, which pays no taxes on the earnings in the account, or a private foundation, which pays very little, a trust pays taxes on earnings at a fairly high rate. A classic use for this sort of trust is an entrepreneur selling a business with some charitable desires. He gives the business to the trust, gets a tax break for doing so, supports a charity for a few years, and then passes the rest on to his kids (or even back to himself.) It doesn’t make sense without a charitable desire, but coupled with one, can be a slick way to reduce some capital gains, income, and estate taxes. There are two types of lead trusts; a Charitable Lead Annuity Trust (CLAT) provides a fixed income stream to the charity and a Charitable Lead UniTrust (CLUT) provides a variable stream.
# 7 Charitable Remainder Trust
As you can see, there are a lot of different ways to give to charity while reducing your tax burden at the same time. Whether you prefer the simplicity of a check or the unique benefits of a complex foundation or trust, there should be an option that will work for you.
What do you think? Do you give to charity? How? Why? Comment below!