For the charitably inclined, there is a silver lining in this year’s higher tax rates for high income people: While Uncle Sam may be taking more from your pockets in the form of taxes this year, you can still use a variety of strategies that may allow you to give more to your favorite charities while reducing some of your taxes. It’s a gift that rewards both the giver and the receiver.
Changes that affect your giving
No changes were made to reduce the cap on the annual charitable deductions for 2013, let alone to phase the deduction out altogether, which was a widespread concern in late 2012. But the following increases (and one new limitation) are in effect for 2013 and 2014, and thereafter as well, unless there are changes to the tax code:
- Top federal ordinary income tax rates increased from 35.0% to 39.6% for married couples filing jointly with taxable income above $450,000 and for single filers with taxable income above $400,000.
- The top federal long-term capital gains tax has increased from 15% to 20% for taxpayers in the 39.6% tax bracket.
- A new Medicare tax of 3.8% is also assessed on the portion of net investment income that exceeds a modified adjusted gross income (MAGI) of $200,000 for single filers and $250,000 for married couples filing jointly. This creates a top effective rate of 43.4% on investment income such as interest and short-term capital gains, and 23.8% for long-term capital gains.
- The Pease limitation has been reinstated for taxpayers with an adjusted gross income (AGI) above $250,000 (singles) or $300,000 (married couples filing jointly). For those affected, the Pease limitation reduces most itemized deductions, including state and local taxes, real estate taxes, charitable contributions, and mortgage interest, by the lesser of 3% of the amount by which a taxpayer’s AGI exceeds the applicable threshold or 80% of the affected itemized deductions. For example, if a married couple filing jointly had an AGI of $350,000 before itemized deductions of $20,000, those deductions would be reduced by $1,500 (3% of $50,000), assuming all the deductions were subject to the Pease limitation.1 Of course, the size of the reduction increases greatly for high-income earners.
How you can use the new tax laws to give more to charity
The silver lining in these tax hikes is that the new higher rates present opportunities to actually increase your giving without increasing your tax bill. If you’re charitably inclined, here are three strategies to consider that can help you make the most of your giving this year.
Strategy #1: Give appreciated securities, rather than cash.2
The donation of cash is, by far, the most common method of charitable giving. All things considered, however, cash donations are in most circumstances 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 reason. Two key advantages are the following:
- Most publicly traded appreciated securities with unrealized long-term gains (meaning they were purchased over a year ago and have a current value greater than their original cost) may be donated to a public charity, and the fair market value may be claimed as an itemized deduction on the donor's federal tax return—up to 30% of the donor’s 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.
- Because the securities are donated rather than sold, capital gains taxes are not owed on the appreciation. The more appreciation the securities have, the greater 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. If they sell the stock first and then donate the cash proceeds to a public charity—assuming their taxable income places them in the 20% capital gains tax rate—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 deduction on their tax return.
If, however, Bill and Margaret donate the stock shares directly to the charity, they are not taxed on the gain. The subsequent deduction increases to $50,000—and, even more importantly, their charity receives an additional $6,000.
One additional consideration: If investors have long-term appreciated assets with an unknown original value, donating the assets directly to charity can save investors the time and trouble of finding out the original basis and paying the applicable capital gains tax.
Strategy #2: 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 (i.e., original cost). In fact, for entrepreneurs who 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 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 the hypothetical example of an entrepreneur donating private stock to a public charity. Karen founded a private software company 20 years ago and intends to sell the business as she heads into retirement. Karen has significant income in the year that her company is sold, and she decides to donate a portion of her shares to charity before selling the business. If she obtains a qualified appraisal, and the donation is completed before the sale is so far along that it would be deemed completed by the IRS, then she should be able eliminate the capital gains tax on the appreciation of the shares that she donates. Also, if she donates her shares to a public charity, she generally should be eligible to claim a tax deduction at the 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, and/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?”)
Strategy #3: Consider offsetting the tax costs of converting a traditional IRA to a Roth IRA with a charitable donation.
Even with higher top income tax rates going into effect this year, 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 IRA, contributions are not tax deductible. They are included in income and subject to income taxes, but withdrawals are tax free.3 Roth accounts generally make sense if you believe your current tax rate will be lower than the one in the years you make withdrawals.
Investors already considering a Roth account conversion for 2013 may wish to consider offsetting some or all of the upfront tax cost of the conversion with a charitable donation. In brief, anytime you convert a traditional retirement savings account into a Roth account, 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, so 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 leveraging the tax advantages.
Once again, before undertaking any of these giving strategies, you should consult your legal adviser, tax adviser, and/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.