2 Tax-Smart Charitable Giving Strategies for the New Tax Era

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Welcome to Hidden Value, the column where Joe Elsasser, CFP, addresses common financial planning issues with insights advisors and their clients may not have considered.

The increased standard deduction under the sweeping tax overhaul passed in 2017 has created an interesting new challenge for taxpayers who give to charity.

Prior to the tax law, the standard deduction was significantly lower. The combination of a low standard deduction and personal exemptions, which have since been eliminated, created an opportunity for people to itemize their charitable contributions and their mortgage interest to allow them a greater deduction than the standard deduction.

However, with the increased standard deduction, far fewer people are expected to itemize. Most clients who give 5 to 10% of their income to charity per year won't have enough deductions to itemize, or if they do itemize, the value will be reduced.

If you have a client who knows that they're going to be contributing to a particular charity on a regular basis for an indefinite number of years, either a qualified charitable distribution or a donor-advised fund can be a much better choice.

Case Study: Donor-Advised Funds

There are a couple of significant benefits to considering a donor-advised fund. By adding appreciated stock or mutual funds to a donor-advised fund, your client may avoid capital gains tax. Additionally, your client could make a large one-time contribution and receive an immediate tax deduction. If the client distributed the contribution over several years instead, they may not meet the increased standard deduction. Let's examine this further with a case study.

Your clients, Martin and Maria Martinez, are married and filing jointly. The have a total of $15,000 in deductions, including $10,000 in state and local taxes (because that deduction is now capped) and another $5,000 of mortgage interest. Their standard deduction is $24,400, which means that the first $9,400 of additional deductions will provide them no benefit as they would not be greater than the standard deduction.

Martin and Maria want to make a $10,000 annual charitable contribution to a local homeless shelter they care about for the next five years.

If Martin and Maria donated $50,000 to a donor-advised fund this year, instead of $10,000 per year, they still lose $9,400 of deductions this year, but they won't lose $9,400 each year for five years. The donor-advised fund strategy would generate an additional $37,600 of usable deductions. If Martin and Maria were donating appreciated stock, they would save the capital gains tax as well.

It's significantly more advantageous for Martin and Maria to add their contribution to a donor-advised fund. Their money still benefits the charity in the same way. Martin and Maria can specify that the donor-advised fund will distribute the money over a five-year period, or however long it lasts, depending on the investment earnings in the account.

Qualified Charitable Distribution

There are a lot of quirks in the U.S. tax code that can cause significant challenges. For instance, a withdrawal from an IRA counts toward an individual's adjusted gross income. If that person donates that money, they get a deduction. But that donation doesn't lower their adjusted gross income; it creates a below-the-line deduction. An artificially high adjusted gross income can create taxation on Social Security benefits and cause capital gains that would have been taxed in the zero percent bracket to become taxable in the 15% bracket.

A qualified charitable distribution can help Martin and Maria avoid these challenges. They can advise their IRA or their 401(k) to allocate the minimum distribution, or a portion of the minimum distribution, directly to the charity instead. Additionally, a qualified charitable distribution can help them avoid phase-outs of other deductions or artificially high Medicare premiums by helping them remain below the Medicare premium threshold.

The Hidden Value

Qualified charitable distributions and donor-advised funds are much more important now than they were before the tax overhaul, but the average American doesn't know about these techniques or why they should use them. Clients are used to writing a check to their favorite charities and leaving it at that. You can offer guidance and help them become more strategic with their charitable giving, which will strengthen your relationship, build trust, and add additional value to their financial strategy.

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Joe Elsasser, CFP, RHU, REBC, developed his Social Security Timing software in 2010 because, as a practicing financial advisor, he couldn't find a Social Security tool that would help his clients make the best decision about when to elect their benefits. Inspired by the success of Social Security Timing, Joe founded Covisum, a financial tech company focused on creating a shared vision throughout the financial planning process.

In 2016, Covisum introduced Tax Clarity, which helps financial advisors show their clients the hidden effective marginal income tax rates that can significantly impact cash flow in retirement. In early 2017, Covisum acquired SmartRisk, software that allows advisors to model "what-if" scenarios with account positions and align a client's risk tolerance with their portfolio risk.