If you’re a charitably inclined investor, there are some giving strategies that could help you maximize the impact of your gifts and minimize your taxes. That means more of your hard-earned money will stay with you and the charities of your choice.
In this article, we’ll cover three ways charitable giving could lower your taxes:
- Qualified charitable distributions (QCDs)
- Tax deductions from cash donations
- Donating long-term appreciated assets
Qualified Charitable Distributions (QCDs)
What are QCDs?
A qualified charitable distribution (QCD) is a direct transfer of funds from a taxable IRA (an individual retirement account) to an operating 501(c)(3) organization.
What are the benefits of QCDs?
To understand the primary benefits of QCDs, you should be familiar with Required Minimum Distributions (RMDs). Starting at age 72, investors with IRAs are obligated to take RMDs every year. A person’s exact RMD amount is determined by an IRS calculation.
As the name suggests, RMDs are required — regardless of whether or not you actually need the funds in a given year. The downside to RMDs — particularly for investors who don’t need the funds — is that they increase the investor’s total taxable income. Depending on your financial situation, an RMD could push you into a higher tax bracket.
That’s where QCDs bring great benefits. With QCDs, you can donate up to $100,000 to charity and satisfy your RMD without increasing your total taxable income. So, if you don’t actually need income from your IRA in a given year, and you’re already planning on making charitable contributions, you can make a QCD instead of a cash withdrawal from your IRA to fulfill your RMD obligation without increasing your tax liability.
This leads to greater long-term tax benefits for you, as well as a greater impact for the charity or charities you’re donating to.
- For example, let’s say your RMD is $1,000, you plan to use your RMD withdrawal to donate to charity, and your taxes on that are 20%.
- If you take the RMD as a cash withdrawal, your after-tax amount is $800. In this case, that means $800 will go to the charity, and the other $200 will be paid in taxes.
- If instead you make a direct contribution through a QCD, your tax-free charitable contribution would be the full $1,000 — and it would not have any consequences on your taxable income.
Keeping your adjusted gross income (AGI) as low as you can is generally a good idea since AGI has wide ranging tax implications on Social Security, itemized deduction phaseouts, medical expenses, Medicare Part B and IRMAA surcharges, and more. Ultimately, taking a QCD leads to a lower AGI without requiring you to itemize deductions on your tax return.
By reducing your tax bill, you’ll keep more of your hard-earned savings, allowing you to donate more, invest more, reach a personal financial goal, pay off debt, or otherwise enhance your standard of living.
One final consideration is that QCDs can actually reduce your RMD in future years by lowering your IRA balance, which is a variable in the IRS calculation for determining RMDs.
QCD rules for eligibility
If you have an IRA and plan to make charitable contributions, you can see how QCDs help fulfill your charitable giving plan, meet your RMD obligation, and minimize your tax bill. So you may be asking: who can actually take QCDs?
To be eligible for a QCD, you must:
- Be at least 70½ years old;
- Have a traditional IRA, inherited IRA, inactive SEP IRA, or inactive SIMPLE IRA
- QCDs are capped at $100,000 per year per eligible individual
- QCDs must be made by December 31 to count toward your RMD
- Any amount donated above your RMD does not “roll over” or count toward fulfilling future RMD obligations
- QCDs must be transferred directly from the custodian to the eligible charitable organization(s)
- The charitable organization must be a 501(c)(3). Private foundations and donor-advised funds do not qualify.
How do you make a QCD?
If you’re working with a financial advisor, they should be able to help you find and complete the appropriate paperwork to make a QCD. You can also reach out to your IRA custodian to request and submit a distribution form.
An important note: The funds must be transferred directly to the operating 501(c)(3) organization(s). That means the check should be made payable to the organization.
If funds are first transferred to you (that is, the check is made payable to you), then it will not qualify as a QCD. It will still count toward your RMD, but it will be considered a taxable distribution.
Charitable gifts as tax deductions
If you’re not 70½ years old or you don’t have an eligible IRA to qualify for a QCD, there are other ways to reap tax benefits from your charitable contributions.
One way is by itemizing your deductions to lower your taxable income and deducting your charitable gifts. In a single year, taxpayers can deduct contributions up to 60% of their AGI. Common itemized deductions include:
- Charitable contributions
- Mortgage interest
- Medical expenses
- State and local taxes
Because the standard deduction is quite high — in 2022, it is $12,950 for single filers, $25,900 for joint filers, or $19,400 for heads of household — it doesn’t make sense for most taxpayers to itemize their deductions. That said, if your itemized deductions do add up to more than your standard deduction, you should consider itemizing to lower your tax liability.
When the itemized amount is close to the standard deduction amount, you might consider charitable bunching. That is, making two or three years worth of planned charitable giving in one calendar year. This strategy allows you to increase your itemizations, maximize your tax deductions, and fulfill multiple years of charitable giving at one time.
Some charitable funds that are not eligible for QCDs — like donor-advised funds — are eligible for tax deductions. A benefit of donor-advised funds is that your donated assets are invested and can grow tax-free until you’re ready to donate them (either all at once or over time) to your preferred charities.
Plus, if you tend to give to multiple charities or plan to give to multiple charities, donor-advised funds are a great solution for efficient, organized giving. Instead of having to chase down tax receipts from every organization you donated to, you get a single tax document for your donor-advised fund contributions.
Lowering your tax bill after a significant windfall
Contributing to a donor-advised fund or eligible 501(c)(3) and itemizing those contributions as tax deductions could be a particularly effective strategy if you’ve experienced a financial windfall (i.e. sold a business, received an inheritance, or got a large bonus). Instead of making small contributions over multiple years, you can make a large contribution and benefit from an immediate tax deduction.
You’ll get the full tax benefits immediately (in the year when you’ve experienced an income windfall), and the lump sum contribution can satisfy your charitable giving goals for multiple years. Plus, deductions in excess of the annual 60% AGI limit can be carried forward up to five years.
Front-loading your charitable giving in this way may be financially optimal if your current tax bracket is higher than you expect it to be down the road (for example, in retirement). You’ll have charitable contributions already set aside for the long-term — freeing up cash from other sources in retirement — and you’ll get a tax benefit immediately.
Donating appreciated securities
Another potential way to gain tax benefits from your charitable giving is by donating appreciated securities like stocks, bonds, or mutual funds, or by donating real estate.
By donating long-term appreciated securities (i.e. securities you’ve held for longer than 12 months), you can avoid paying capital gains taxes and maximize the value of your gift since qualifying nonprofits are exempt from capital gains taxes.
The benefits of donating appreciated securities are compounding:
- You’re able to deduct the full fair market value of the investment as a charitable deduction (up to 30% of your AGI)
- You (and the charity) permanently avoid paying capital gains taxes on the donated securities
- The charity receives the full value of the securities (vs. after-tax value)
- You’ll have more cash available to either reinvest or direct toward other personal financial goals and priorities
- It may help you stay in line with your portfolio diversification strategy without forcing you to sell off holdings and pay capital gains taxes
Similar to a QCD, this strategy only works if you donate the assets directly to the operating charitable organization. That is, you cannot maximize the tax benefits if you sell the securities and donate the proceeds. At that point, the proceeds would be subject to capital gains taxes, ultimately lowering the total amount available to donate.
Once the securities are transferred to the charitable organization, they can choose to either sell the appreciated assets or hold onto the investments and let them grow.
Conclusion: Are QCDs or charitable tax deductions right for you?
To answer this question, you first need to answer if you’re planning to make charitable contributions in the first place. From a purely wealth building perspective, the optimal thing to do is simply keep the assets from your distributions — whether from RMDs or appreciated assets — and take the associated tax hits.
That said, if you are charitably inclined and are already planning to make charitable contributions, these are effective strategies to consider.
QCDs are typically best for people who:
- Are at least 70½ years old;
- Have an eligible IRA;
- Are subject to RMDs (or will be subject to RMDs in the future);
- Don’t actually need part or all of their RMD in a given year;
- Want to keep their taxable income down
Donating appreciated securities
Donating appreciated securities or real estate typically makes sense for people who:
- Aren’t subject to RMDs (or have already reached their QCD limit);
- Don’t have a QCD-eligible IRA;
- Want to contribute to a donor-advised fund or private foundation
Cash donations that are tax deductible
Making cash donations that are eligible for itemized deductions are usually best for people who:
- Are younger than 70½ years old;
- Expect their total itemized deductions to exceed the standard deduction;
- Don’t have long-term appreciated securities;
- Experience a significant financial windfall (i.e. inheritance, sale of a business, large bonus, etc.) in a given tax year;
- Want to contribute to a charitable organization or fund that does not accept donated securities
While the specific savings, technical aspects, and eligibility requirements of each strategy are different, the commonality among all of them is that, when used effectively, they help investors maximize their charitable giving while minimizing their tax liability. For a philanthropically motivated investor, that’s a win-win.
If you’re interested in taking advantage of these tax planning and charitable giving strategies, our team of fiduciary financial planners is here to help. We will work with you to explore all the available options and evaluate how they fit into your overall financial plan. Book a free discovery call to learn more.
The information provided in this material is for informational purposes only and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional.