The 2017 Tax Cuts and Jobs Act made sweeping changes to our tax laws. One of the most significant was the nearly doubling of the standard deduction, an amount the IRS allows all tax filers to deduct from their income each tax year. For the 2021 tax year, the standard deduction is $12,550 for single filers and $25,100 for joint filers.
As an alternative to the standard deduction, tax filers have the option to itemize their deductions. This is a process of compiling various IRS approved deductions, thereby reducing taxable income for the year. When the cumulative value of those deductions exceeds the standard deduction, it naturally makes sense to itemize. While the higher standard deduction benefits far more taxpayers than before, the charitable deduction is still available for taxpayers who choose to itemize deductions. As a result of the change to the standard deduction, there are three key planning strategies to consider for those with charitable goals.
“Lumping” Charitable Donations
Prior to the passing of the Tax Cuts and Jobs Act, approximately 37 million tax filers chose to itemize deductions. Many of those filers made charitable donations on an annual basis, deducting those amounts from their income. Under the current tax law, approximately 21 million filers who previously itemized now use the standard deduction, surrendering the tax benefit of their annual donations. While many continue to donate to their favorite charities with or without a tax benefit, there is no doubt the new law curtailed the incentive to give.
One strategy that may appeal to donors is to “lump” several years’ worth of small annual donations into one tax year. For example, suppose a single filer has $10,000 in itemized deductions before charitable donations. These itemized deductions would have meaningfully exceeded the standard deduction amount in the prior tax law (i.e., $6,350), but not under the current law (i.e., $12,550). If that person typically donates $1,000 to various charities during the year, the total itemized deductions will be $11,000, still below the standard deduction level. Although this person benefits from the current tax law with a $12,550 standard deduction, the tax benefit of the charitable donations is lost. On the other hand, grouping three years’ worth of $1,000 donations can push the total itemized deduction to $13,000 for a year, clearing the standard deduction hurdle and providing a tax benefit in the year the lumped donations are made. The taxpayer can continue to use the standard deduction in the two non-donating years. This approach can provide an ongoing tax benefit while also encouraging donations to important causes.
Donor Advised Funds
If more people start donating larger sums to charities, we can expect a rise in the use of donor advised funds or charitable trusts. Donor advised funds, in particular, can be appealing for both the control they provide over timing of donations and the ease of administration. A donor advised fund is a pooled charitable vehicle that is operated and controlled by sponsoring organizations such as a community foundation or financial services organization. They allow donors to establish and fund an account by making irrevocable, tax-deductible contributions of cash, appreciated securities, or other personal property to the charitable sponsor.
In the “lumping” strategy example, a donor advised fund could work very well. A hypothetical $3,000 donation can be made to a donor advised fund, a tax deduction can be received, and the actual donations to the charities can continue to be made on an annual basis. This allows the charity to continue receiving the $1,000 amount per year as opposed to the one-time lump sum. Also, if the taxpayer has highly appreciated securities, those securities can be gifted to the donor advised fund in-kind. In-kind donations allow the donor to avoid capital gains tax, and they enable the fund to invest the assets over time without capital gains taxes when the security is eventually sold.
Qualified Charitable Distribution
Taking advantage of the qualified charitable distribution (QCD) strategy may be more valuable than ever under current tax law. The strategy allows an IRA owner age 70 ½ and older to give up to $100,000 from their IRA directly to a charity of the owner’s choice. The benefits of a QCD can be significant because it satisfies charitable giving, counts towards required minimums distributions (RMD) for that year, and has tax advantages for the IRA owner and charity. For example, the charity does not pay income tax on the distribution it receives, and although the IRA owner does not receive an income tax deduction for the contribution, the amount donated to charity is excluded from taxable income. This may put the IRA owner into a lower income tax bracket and may allow the IRA owner to avoid certain penalties that come with a higher adjusted gross income, such as higher Medicare premiums, the 3.8% tax on net investment income (if they own taxable accounts), and perhaps minimize or avoid the alternative minimum tax. To make a qualifying distribution, you must direct your IRA custodian or trustee to send the distribution directly to the charity (or you can request a check made payable to the charity). It’s worth mentioning that Donor Advised Funds and private foundations are not qualifying charities for QCDs.
The QCD can be very appealing for individuals who may not rely on their full RMD amount to meet annual spending and who are interested in making charitable donations.
It is important to consult with your tax advisor to determine if any of the strategies outlined above are appropriate for your specific charitable goals.
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