As the holidays approach, many people look for ways of combining their desire to help the causes they believe in with their desire to save on taxes. For the charitably inclined, there are strategic ways of giving that can accomplish both goals.
Tax laws that affect your giving
In effect in 2017 for high-income earners (although changes in tax law could affect these rules):
- Top ordinary income tax rate: 39.6%
- Top long-term capital gains tax rate: 20%
- Medicare surtax of 3.8% on net investment income over certain thresholds*
- Pease limitation reduces some itemized deductions for higher income taxpayers**
*In 2017, the personal exemption is subject to a phase-out that begins with adjusted gross incomes of $261,500 ($313,800 for married couples filing jointly). It phases out completely at $384,000 ($436,300 for married couples filing jointly.)
**For the 2018 tax year, the Pease limitations are based on filing status:
$266,700 for a single taxpayer
$320,000 for married couples filing jointly or surviving spouses
When you hit these itemized deduction income thresholds, your Schedule A amounts for home mortgage interest, state and local tax claims, charitable gifts and miscellaneous deductions is reduced by either 3% of your adjusted gross income in excess of your threshold amount or 80% of the amount of itemized deductions you otherwise could claim for the tax year.
Generally, if you itemize your deductions, making charitable contributions can decrease your tax bill, and with higher tax rates for high‐income earners, there is an increased tax benefit for charitable contributions.
However, if Congress passes a tax reform bill this year, it could include a proposal to increase the standard deduction. That could mean fewer people will qualify for itemized deductions such as charitable gifts.
In the giving mood? Here are 5 strategies to consider that can help you make the most of your giving this year:
1. Give appreciated securities, rather than cash
Donations made by cash or check are, by far, the most common methods of charitable giving. However, contributing stocks, bonds, or mutual funds that have appreciated over time has become increasingly popular in recent years, and for good reasons.1
Most publicly traded securities with unrealized long‐term gains (meaning they were purchased more than a year ago and have increased in value) may be donated to a public charity, without the need to sell them first. When the donation is made, the donor can claim the fair market value as an itemized deduction on their federal tax return—up to 30% of the donor’s adjusted gross income (AGI). Other types of securities, such as restricted or privately traded securities and donations to nonpublic charities, may also be deductible, but additional requirements and limitations may apply.
When the securities are donated, no capital gains taxes are owed because the securities were donated, not sold. The greater the appreciation, the bigger the tax savings will be. Here is a hypothetical example: A couple, Bill and Margaret, purchased a publicly traded stock 10 years ago for $20,000, and it is now valued at $50,000. Let's assume their taxable income places them in the 20% capital gains tax rate and they don’t have any long‐term capital losses available to them to utilize. If they sell the stock first and then donate the after‐tax proceeds to a public charity, they will pay a federal long‐term capital gains tax of $6,000 on the $30,000 of gains, leaving $44,000 ($50,000 − $6,000) for their charity, and they should then be able to claim the $44,000 donation as a federal tax deduction.
If, however, Bill and Margaret donate the stock directly to the charity, the tax calculation is based not on the gain but on the amount donated, and their tax deduction increases to $50,000. As a result of using this method, their charity receives an additional $6,000. One additional consideration: If you have long‐term appreciated assets with an unknown original value, donating the assets directly to charity can save you the time and trouble of finding out the original basis and paying the applicable capital gains tax.
2. Consider establishing a donor-advised fund
A donor-advised fund (DAF) is a program of a public charity that allows donors to make contributions to the charity, become eligible to take an immediate tax deduction, and then make recommendations on their own timetable for distributing the funds to qualified charitable organizations. With charities that have DAF programs, you can make irrevocable contributions to the charity, which establishes a DAF on your behalf. There are a number of public charities, including Fidelity Charitable®, that sponsor DAFs. You can then recommend grants to other eligible charities—generally speaking, IRS‐qualified 501(c)(3) public charities—from your DAF.
Establishing a DAF can be a particularly useful strategy at year‐end because it allows you to make a gift and take the tax deduction immediately but doesn't require you to decide on the charities to support with grant recommendations. It can be a great way for charitably inclined individuals to offset a year with unexpectedly high earnings, or to address the tax implications of year‐end bonuses.
3. Consider using a charitable donation to offset the tax costs of converting a traditional IRA to a Roth IRA
Even with higher top income tax rates, many investors are considering converting from a traditional IRA to a Roth IRA. In addition, the American Taxpayer Relief Act of 2012 made it possible for active employees to convert a 401(k), 403(b), or 457(b) plan account to its Roth counterpart within the same plan.
The most essential difference between traditional retirement savings vehicles (whether they're IRAs or workplace plans) and the Roth versions is that with the former, contributions are usually tax deductible in the year they are made and can grow tax deferred within the account; the contributions and earnings are then taxed at "the back end" (i.e., upon withdrawal). Roth IRA contributions are not tax deductible. You can withdraw contributions you made to your Roth IRA anytime, tax and penalty free. However, you may have to pay taxes and penalties on earnings in your Roth IRA.2
Roth accounts may make sense if you believe your current tax rate is lower than it will be in the years you’ll make withdrawals; however, there are many other factors that must be evaluated to determine what makes sense in your individual situation. (For more on Roth conversions, read Viewpoints on Fidelity.com: Tax-savvy Roth IRA conversions.)
Any time you convert a traditional retirement savings account into a Roth, you will owe taxes on any pretaxed amounts converted. Depending on the amount converted and your tax rate, the taxes on the Roth conversion can be significant.
Converting in a year in which you can claim a large tax deduction, such as a charitable deduction, can be helpful in offsetting the conversion taxes and may give you an opportunity to give to a charity while also reducing your taxes.
4. Consider donating complex assets
Donors may also contribute complex assets—such as private company stock, restricted stock, real estate, alternative investments, or other long-term appreciated property—directly to charity. The process for making this type of donation requires more time and effort than donating cash or publicly traded securities, but it has distinct advantages. These types of assets often have a relatively low cost basis. In fact, for entrepreneurs who have founded their own companies, the cost basis of their private C corp or S corp stock may effectively be zero.
In cases in which these assets have been held for at least a year, the outright sale of the asset would result in a large capital gains tax for the owner. If, however, the asset is donated directly to a charity and the charity then sells the asset, the original owner is, in many cases, able to eliminate capital gains taxes on the sale of the assets, while potentially taking a charitable donation deduction as well.
Take this hypothetical situation: Karen is an entrepreneur who founded a private software company 20 years ago and intends to sell the business as she heads into retirement. Karen decides to donate a portion of her shares to a public charity before selling the business. If she obtains a qualified appraisal and completes the donation before the sale is finalized, she should be able to eliminate capital gains taxes on the appreciation of the donated shares, and claim a tax deduction for them,3 based on the company's appraised value.
Contributing these complex, non-publicly traded assets to charity, however, involves additional laws and regulations, so investors should consult their legal, tax, or financial adviser. Also, not all charities have the administrative resources to accept and liquidate such assets. But many public charities with DAF programs, like Fidelity Charitable, are able to accept these assets and can work with advisers, providing them with guidance throughout the process. (For more on DAFs, read Viewpoints on Fidelity.com: Strategic giving: Think beyond cash)
5. Consider a qualified charitable distribution (QCD) from an IRA
The qualified charitable distribution (QCD) option emerged after Hurricane Katrina in 2005 and was made permanent by Congress in 2015.
If you are at least age 70½, have an IRA, and plan to donate to charity this year, another consideration may be to make a QCD from your IRA. This action can satisfy charitable goals and allows funds to be withdrawn from an IRA without any tax consequences. A QCD can also be appealing because it can be used to satisfy your required minimum distribution (RMD).
Generally speaking, QCDs may be useful in situations where the charitable deduction could not be fully utilized—either because your itemized deductions (including the charitable contribution) fall below the threshold of the standard deduction in the first place, or because your charitable contribution is so large that it exceeds the 30% or 50% of AGI contribution limits and must be carried forward. QCDs may also be useful for high-income clients who are subject to phaseouts on their itemized deductions.
QCDs may be most appealing if you have few other deductions or if you are already close to your charitable deduction limitations. Because the tax-free QCD is never reported as a deduction it is not counted against the charitable limits.
Alternatively, if you are subject to an RMD and have a desire to contribute to a charity, you could take the RMD proceeds as a taxable distribution and use them to make a charitable donation. Your IRA distribution would then be reported as income, but the subsequent charitable contribution using the proceeds from the RMD would generally offset the tax consequences—to the extent that the limits and phaseouts allow it.
Certain charities are not eligible to receive QCDs, including DAFs, private foundations, and supporting organizations as described in IRC Section 509(a)(3) (i.e., charities carrying out exempt purposes by supporting other exempt organizations, usually other public charities). You are not allowed to receive any benefit in return for your charitable donation. For example, if your donation covers your cost of playing in a charitable golf tournament, your gift would not qualify as a QCD. Some smaller charities may not be equipped to handle QCDs and may prefer to receive your contributions via your DAF.
Finally, note that QCDs are limited to $100,000 in 2017, so if your RMD is larger than that, you might still need to take a conventional distribution in addition to your QCD.
Tip: Seek professional advice about QCDs. Visit Fidelity's Learning Center for more on QCDs.
Once again, before undertaking any of these giving strategies, you should consult your legal, tax, or financial adviser. But, properly employed, each of the strategies represents a tax‐advantaged way for you to give more to your favorite charities.