As the holidays approach, many people look for ways of combining their desire to do good with their desire to save on taxes. For the charitably inclined, there are strategic ways of giving that can help the giver and the receiver.
Tax laws that affect your giving
Tax changes that went into effect in 2013 raised the income tax rate for high-income earners, making charitable deductions a more attractive option. (See graphic right.)
Generally, if you itemize your deductions, making charitable contributions can decrease your tax bill, but the higher tax rates for high-income earners add an increased tax benefit for charitable contributions. In the giving mood? Here are four strategies to consider that can help you make the most of your giving this year.
Strategy #1: Give appreciated securities, rather than cash.1
The donation of cash or check is, by far, the most common method of charitable giving. All things considered, however, cash donations are generally not the most tax-efficient way to give. Contributing stocks, bonds, or mutual funds that have appreciated over time has become increasingly popular in recent years, and for good reasons.
- Most publicly traded securities with unrealized long-term gains (meaning they were purchased over a year ago and have increased in value) may be donated to a public charity, and the donor can claim the fair market value as an itemized deduction on his or her federal tax return—up to 30% of the donor’s adjusted gross income. 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.
- No capital gains taxes are owed, because the securities are 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. If they sell the stock first and then donate the proceeds after-tax 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, which Bill and Margaret should be able to claim as a federal tax deduction.
If, however, Bill and Margaret donate the stock directly to the charity, they are not taxed on the gain. The subsequent deduction increases to $50,000—and, what’s more, 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.
Strategy #2: Consider establishing a donor-advised fund
With charities that have donor-advised fund (DAF) programs, you can make irrevocable contributions to the charity, which establishes a DAF on your behalf. A range of public charities, including Fidelity Charitable®, sponsor donor-advised funds. You can then recommend grants to other eligible charities—generally speaking, IRS-qualified 501(c)(3) public charities—from your DAF.
Establishing a donor-advised fund can be a particularly useful strategy at year-end because it allows you to make a gift and take the tax deduction immediately, but take your time to decide where the dollars will go. It can be a great way to offset a year with unexpectedly high earnings, or address the tax implications of year-end bonuses.
Strategy #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 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. (For more on Roth conversions, read Viewpoints: “Roth IRA conversions.”)
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). With a Roth, contributions are not tax deductible. They are included in income and subject to income taxes, but withdrawals are tax free.2 Roth accounts generally make sense if you believe your current tax rate will be lower than the one in the years you’ll make withdrawals.
Any time you convert a traditional retirement savings account into a Roth, you will owe taxes on any pretax monies converted. Depending on the amount converted and your tax rate, the taxes on the conversion can be significant. It’s generally unwise to pay these taxes out of the retirement account being converted, as doing so would reduce your retirement savings and the account’s growth potential.
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. While your total out-of-pocket cost will be higher, this is still an opportunity to give to charity while reducing your taxes.
Strategy #4: Consider donating complex assets.
Donors may also contribute complex assets—such as private company stock, restricted stock, real estate, alternative investments, or other personal property—directly to charity. The process requires more time and effort than the gifting of cash or publicly traded securities, but has distinct advantages. (For more on donating complex assets, read Viewpoints: “Strategic giving: thinking beyond cash donations.”)
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 be zero. In cases where 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 receiving 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, she should be able eliminate capital gains taxes on the appreciation of the donated shares, and claim a tax deduction for them3, based on the company’s appraised value.
Contributing these complex, nonpublicly traded assets to charity, however, involves additional laws and regulations, so investors should consult their legal adviser, tax adviser, or financial adviser. Also, not all charities have the administrative resources to accept and liquidate such assets. But many public charities with donor-advised fund programs, like Fidelity Charitable, are able to accept these assets and can work with advisers, providing guidance throughout the process. (For more on donor-advised funds, read Viewpoints: “Getting Serious about Your Giving?”)
Once again, before undertaking any of these giving strategies, you should consult your legal adviser, tax adviser, or financial adviser. But, properly employed, each of the strategies represents a tax-advantaged way for you to give more to your favorite charitable organizations and causes.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917