By Dr. James M. Dahle, WCI Founder
Guess what? The IRS (and thus Congress, the government, and Americans) wants you to give to charity. It knows (like you should) that you will come out behind financially for making those charitable contributions, but it also wants 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 those who participate in giving to charity.
#1 Charitable Donations Are Tax-Deductible
This is the one that most people know about. If you write a check to charity, you can take the amount of that charitable contribution as an itemized deduction on Schedule A. Of course, if you take the standard deduction ($12,550 and $25,100 married for 2021, and $12,950 and $25,900 married for 2022), that donation isn't going to reduce your taxes one lick. But if you do itemize and you have at least $12,550/$25,100[2021] of other itemized deductions, such as taxes and mortgage interest, the charitable donation should be completely deductible.
If your marginal tax rate is 37% and you donate $10,000, that should reduce your tax bill by $3,700. Note that paying $10,000 to reduce your taxes by $3,700 is not a winning strategy. But if you're going to give the money anyway, it's nice to do it with pre-tax dollars. This helps you have $3,700 to spend somewhere else, or thought of another way, it helps you give an extra $3,700 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 one-quarter 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 [2021] for a deduction of $70 ($26 off your tax bill if your marginal rate is 37%.) 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 in 2018 when I bunched my deductions into 2017 and took the standard deduction for 2018.
#2 Charitable Contributions Offset 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? You get your usual charitable deduction, and neither you nor the charity has to pay the long-term capital gains taxes. Be sure you've owned the shares for 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 Funds Allow You to Save and Invest
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 $500,000 in the account (those fees get lower the more you contribute to the DAF).
So, why do people (who aren't jerks) actually use a DAF? Well, there are 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. When I originally wrote this post in 2018, he was in his peak earnings years (in 2019, he retired from medicine at 43). He planned to have a dramatically lower taxable income for years and years afterward while taking the standard deduction, and he wanted to make sure he got the tax break so he could give as much as possible to his favorite charities. Plenty 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. Let's be honest. There are some reasons to make the contribution to the DAF now and distribute it to charity later (not sure which charity, charity can't handle it all at once, tax play for money you're not yet ready to give, using the giving to teach children throughout life etc.).
The second reason 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. 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 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 p*rn.” 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, you get to avoid “pulling a jerk move” and 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 Are Easier Than You Think
What is a Qualified Charitable Distribution (QCD)? It's 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 (which begins when you turn 72). 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.
Giving enriches both the giver and the receiver
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 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 Foundations Have Benefits
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 it 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 Can Reduce Estate Taxes
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. That person 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 their kids (or even back to themself). It doesn't make sense without a charitable desire, but coupled with one, it 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 Earnings Are Tax-Exempt
The other type of trust, often considered the “inverse” of a charitable lead trust, is a charitable remainder trust. In this case, you donate cash (or more likely an appreciated business) to the trust, get an upfront deduction, and collect annuity payments for the rest of your life (or designate them to go to one of your heirs for the rest of their life). Upon the death of you (or your heir), your designated charity gets whatever is left in the trust. Again, you can mess with the figures a bit, but in general, the more that goes to the charity, the larger your upfront deduction. Unlike the charitable lead trust, the earnings in a CRT are tax-exempt. The income stream, of course, is fully taxable to its recipient. A Charitable Remainder Annuity Trust (CRAT) provides a fixed income stream, and a Charitable Remainder UniTrust (CRUT) provides a variable stream.
As you can see, there are a lot of different ways to make charitable contributions 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!
[This updated post was originally published in 2018.]
