While the 2017 Tax Cuts and Jobs Act (the “Tax Act”) introduced new tax rules affecting high net worth individuals and multimillion-dollar companies, one major change directly affects the rest of us: the increased standard deduction. This article explores the impact of the increased standard deduction on return filing and charitable giving and further explains how you can use tools like donor-advised funds and bunched charitable contributions to minimize your taxes.
The Standard Deduction
The Tax Act nearly doubled the standard deduction to $12,000 per individual (or $24,000 for married couples filing jointly). The standard deduction is the deduction every individual can apply toward and reduce his or her taxable income. Compare this with itemized deductions, providing a higher reduction of taxable income when the taxpayer’s eligible deductions (e.g., charitable contributions, state and local taxes, and home mortgage interest) are greater than $12,000.
This increased standard deduction has led many taxpayers, who previously filed itemized returns and utilized the charitable deduction, to take the standard deduction because their itemized deductions were less than $12,000. This article is directed at those taxpayers taking the standard deduction yet still making annual, charitable contributions.
For the remainder of this article, I will refer to the following example:
- Jane is an unmarried individual who makes $85,000 each year;
- Jane pays $5,000 in home mortgage interest each year;
- Jane pays $2,000 in state and local taxes each year;
- Jane generously gives $5,000 to a local non-profit organization each year
Based on the numbers in the example, Jane has total itemized deductions of $12,000, equal to the standard deduction. Jane decides to take the standard deduction and avoid filing the somewhat daunting itemized tax return. Unfortunately, this strategy ignores the opportunity for Jane to utilize bunched charitable contributions and a donor-advised fund to increase her itemized deductions, lower her taxable income, and even place her in a lower tax bracket.
Bunched Charitable Contributions
Bunched charitable contributions involve a taxpayer making a charitable contribution every other year, or more periodically, while maintaining the same annual average. For example, instead of giving $4,000 to a charitable organization on an annual basis, a taxpayer would give $8,000 every other year.
Bunching charitable contributions allow taxpayers to increase their itemized deductions in the year the contribution is made and take advantage of other itemized deductions with the goal of exceeding the standard deduction.
In our example, Jane’s itemized deductions are equal to the standard deduction. Instead of making annual charitable contributions of $5,000, she would be better off utilizing bunched contributions and instead giving $10,000 every other year. Using this method would give Jane itemized deductions of $17,000 in contribution years and allow her to take the $12,000 standard deduction in non-contribution years. Overall, Jane’s tax liability decreases in contribution years and sacrifices less itemized deductions in non-contribution years ($7,000 instead of $12,000).
What should Jane do when the charity expresses concern that this plan decreases its capital in non-contribution years?
[enter donor-advised funds]
Donor Advised Funds
A donor-advised fund (DAF) is an investment account used to make charitable contributions to the organization of your choice. Essentially, a DAF allows a donor to irrevocably contribute assets to an investment account, take the deduction for the contribution in the year such assets are placed into the account, and control the timeline of distributions to the organization(s) of choice.
Paired with bunched charitable contributions, DAFs enable a taxpayer to take increased deductions available under the bunched contributions method, ensure the charitable organization receives annual distributions, and also increase the value of the money donated by placing assets in an investment account. DAFs also provide the opportunity for taxpayers to avoid capital gains taxes on highly-appreciated, low basis assets because taxpayers generally do not have to pay capital gains taxes on charitable contributions but still get to take the asset’s fair-market value as a deduction.
Taxpayers making contributions to charitable organizations but only utilizing the standard deduction should consult a financial advisor, tax preparer, or attorney about incorporating bunched charitable contributions and DAFs into their financial plan to take advantage of itemized deductions and decrease their total tax liability.
This information is general in nature and should not be construed as tax or legal advice.