Making charitable donations is a generous way to support causes you care about, and it can also help reduce your tax liability. If you’re considering donating cash, property, or other assets, it’s important to complete your donations by December 31st to take full advantage of deductions on your 2024 tax return. When donating property, such as real estate, you can typically deduct the fair market value, which could significantly lower your taxable income. To ensure you’re maximizing your charitable deductions, it’s essential to consult a tax advisor for guidance on structuring your donations.
Tax-Efficient Charitable Giving: Should IRA Withdrawals Be Used for Donations?
In some situations, making charitable contributions through IRA withdrawals, particularly Required Minimum Distributions (RMDs), could be the most tax-efficient option. The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the option of Qualified Charitable Distributions (QCDs) from Individual Retirement Accounts (IRAs) permanent. This means individuals aged 70.5 or older who are required to take RMDs from IRAs, but don’t need the funds for living expenses, can donate up to $100,000 directly from their IRA to qualified charitable organizations. These IRA withdrawals, which would normally be taxable, are excluded from taxable income, helping to lower your Adjusted Gross Income (AGI).
For taxpayers in this age group, contributing directly from an IRA can be a more tax-efficient way to give to charity, compared to making cash donations or donating appreciated property. Here’s a comparison of these three methods of charitable giving:
Background: IRA Charitable Contributions
The option to donate directly from an IRA to charity was first introduced by the Pension Protection Act of 2006, which allowed these contributions to be excluded from taxable income. However, the provision was initially temporary and lapsed after the 2007 tax year. Subsequent tax laws temporarily reinstated this benefit, often at the end of a tax year, creating uncertainty for taxpayers as to whether or not the provision would continue.
For example, in 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act reinstated the provision retroactively for 2010 and 2011. The benefit lapsed for 2012, only to be reinstated in 2013 by the Taxpayer Relief Act. Fortunately, the PATH Act of 2015 permanently extended this provision, allowing taxpayers to plan with greater certainty.
Now, taxpayers over 70.5 years old can take advantage of this permanent law, making IRA charitable distributions a reliable option for tax-efficient giving.
Rules for Making Qualified Charitable Distributions (QCDs) from IRAs
Qualified Charitable Distributions (QCDs) provide a unique tax advantage for IRA owners who want to contribute to charity. A QCD allows individuals aged 70.5 or older to donate directly from their IRA to a qualified charity, potentially lowering their taxable income. However, there are specific rules to follow, including which types of IRAs are eligible and the conditions for making a valid QCD.
Eligibility of IRAs for QCDs
A QCD can be made from most types of IRAs, excluding SEP IRAs (as defined in Section 408A of the Internal Revenue Code) and deemed IRAs (Section 408(p)). However, taxpayers can always roll over funds from other retirement accounts like 401(k)s or 403(b)s into an IRA if their IRA balance is insufficient to meet the donation amount.Age Requirements and Timing
To make a QCD, an individual must be at least 70.5 years old. This does not mean the donation can be made in the year the individual turns 70.5—it must be after reaching this age. Typically, Required Minimum Distributions (RMDs) are required to begin by April 1st of the year following the year the individual turns 70.5, and QCDs can only be made after this age.How Donations Must Be Made
For the distribution to qualify as a QCD, the IRA trustee must make the payment directly to the charity. However, if a check is issued from the IRA, the IRA owner can deliver it directly to the charity.Eligible Charities for QCDs
QCDs can only be made to organizations that are described under Section 170(b)(1)(A) of the Internal Revenue Code. This excludes private foundations (Section 509(a)(3)) and donor-advised funds (Section 4966(d)(2)).Contribution Limits
For 2024, the annual limit for QCDs is $100,000 per IRA owner. If both spouses are eligible, each can contribute up to $100,000, allowing a couple to donate as much as $200,000 in total, provided they both meet the requirements.Tax Treatment of QCDs
To be considered a QCD, the distribution must otherwise be taxable as income. If an IRA contains both pre-tax and after-tax dollars (from nondeductible contributions), the IRS does not apply the usual pro-rata rule for calculating the tax treatment of distributions. Instead, QCDs are considered to come entirely from the pre-tax portion of the IRA.
Example for 2024: Eugene’s IRA QCD
Let’s consider Eugene, who is 72 years old and has a traditional IRA with a balance of $200,000. Of this balance, $180,000 consists of pre-tax contributions, and $20,000 consists of after-tax contributions. Eugene decides to make a $50,000 QCD to his favorite charity.
Step 1: Calculate the Taxable Distribution
Eugene’s QCD of $50,000 will be considered to come entirely from the $180,000 in pre-tax dollars, meaning none of the distribution will be considered taxable from the $20,000 of after-tax dollars.Step 2: Adjusted Gross Income (AGI) Reduction
Since the distribution of $50,000 comes from pre-tax funds, it reduces Eugene’s AGI by the full amount, lowering his taxable income for 2024.
By taking advantage of a QCD, Eugene not only satisfies his RMD requirements but also avoids the tax on the $50,000 distribution and reduces his AGI, helping to lower his tax liability for the year.
Evaluating the Tax Efficiency of Charitable Donations
A practical way to assess the tax efficiency of charitable contributions is by calculating the reduction in the cost of giving as a percentage, compared to making a non-deductible cash donation to a qualified charity. The greater the reduction, the more tax-efficient the donation. Generally, the higher the taxpayer’s marginal tax rate, the larger the reduction in the cost of giving, provided the donation either reduces taxable income or qualifies for a tax deduction.
Example 1: Jerry’s Donation and Tax Efficiency
Jerry donates $1,000 in cash to a qualified charity. His marginal tax rate is 25%, but he does not itemize deductions. Because he cannot deduct the donation, his after-tax cost is the same as his pre-tax cost, so there is no tax benefit from the donation.
If Jerry decides to itemize deductions, he can deduct the $1,000 donation from his taxable income. In this case, his after-tax cost becomes $750, calculated as:
$1,000 × (1 − 25%) = $750.
This represents a 25% reduction in his donation cost, calculated as:
($1,000 − $750) / $1,000 = 25%.
Example 2: Jane’s Donation and Tax Efficiency
Now, consider Jane, who donates $1,000 to a qualified charity. She is in the 35% marginal tax bracket and itemizes her deductions. Her after-tax cost of the donation is calculated as:
$1,000 × (1 − 35%) = $650.
This means her tax benefit reduces her cost of giving by 35%, as shown by:
($1,000 − $650) / $1,000 = 35%.
Reducing the Cost of Charitable Giving through IRA RMDs
Once a taxpayer reaches the age of 70.5, they are required to start taking Required Minimum Distributions (RMDs) from their Individual Retirement Accounts (IRAs). At this point, tax-free charitable donations from IRAs become an option. When a taxpayer uses RMD income for charitable donations, the tax savings are equal to the amount of the donation multiplied by the taxpayer’s marginal tax rate. This is because the amount that would have otherwise been taxable is excluded from taxable income, lowering the taxpayer’s tax burden.
However, a higher Adjusted Gross Income (AGI) can lead to additional tax costs, such as phase-outs of deductions, the Medicare surtax, and increased Medicare premiums. These extra costs result in a higher effective marginal tax rate than the taxpayer’s stated rate. By reducing AGI through tax-free charitable contributions from IRA RMDs, taxpayers can avoid some of these additional taxes, making their charitable giving even more cost-effective.
In many cases, the exclusion of RMD income for charitable donations can lower AGI to a level that reduces or eliminates these extra costs. This makes giving from an IRA more advantageous than simply making a deductible cash contribution, as it helps reduce both the taxpayer’s taxable income and the hidden tax burdens associated with a higher AGI. The following sections explore the specific situations where this tax reduction is most impactful.
Key Scenarios Where Charitable IRA RMD Withdrawals Reduce the Cost of Giving More Than Cash Contributions
For taxpayers aged 70.5 and older, withdrawing funds from an IRA to make charitable contributions can often result in a lower overall cost of giving compared to simply making cash donations and itemizing deductions. This is because reducing taxable income through IRA charitable withdrawals can help avoid certain tax penalties and surcharges that apply when AGI (Adjusted Gross Income) rises. The following are some of the primary tax consequences that increase AGI and can be mitigated through IRA charitable giving:
Medicare Surtax on Investment Income
Taxpayers with net investment income above specified AGI thresholds are subject to a 3.8% Medicare surtax. By lowering AGI through IRA RMD withdrawals for charity, taxpayers can reduce or avoid triggering this surtax, which would otherwise apply to their investment income.Phase-Out of Itemized Deductions
For higher AGI levels, the value of itemized deductions is reduced by 3% for each dollar above specified income thresholds. By donating through IRA RMD withdrawals, which are excluded from taxable income, taxpayers can avoid triggering this phase-out and maintain the full benefit of their itemized deductions.Phase-Out of Exemptions
The phase-out of personal exemptions applies once AGI exceeds certain levels. Lowering AGI through IRA charitable withdrawals can help reduce or eliminate this phase-out, thus preserving the value of personal exemptions.Increased Taxation of Social Security Benefits
As AGI rises, a larger portion of Social Security benefits becomes taxable. By reducing AGI with IRA RMD withdrawals to charity, taxpayers can lower the amount of their Social Security benefits that are subject to tax.Higher Medicare Premiums
Higher AGI levels can push taxpayers into a higher premium bracket for Medicare Part B and Part D. By using IRA RMD withdrawals for charitable contributions, taxpayers can lower their AGI and avoid the higher premiums that come with crossing these income thresholds.
Medicare Surtax on Net Investment Income
The Medicare surtax is a 3.8% tax applied to the lesser of a taxpayer’s net investment income or modified adjusted gross income (MAGI) that exceeds certain thresholds. These thresholds are:
- $200,000 for single or head-of-household filers
- $250,000 for married couples filing jointly
- $125,000 for married individuals filing separately
MAGI is calculated by adding any net foreign income excluded from gross income to a taxpayer’s adjusted gross income (AGI).
Example 1: John and Jane’s Medicare Surtax Calculation
John and Jane Smith, who file jointly, have a MAGI of $259,000, which includes $15,000 in net investment income. The Medicare surtax will be applied to the lesser of their net investment income or the excess MAGI over the $250,000 threshold for joint filers.
Step 1: Determine the amount subject to the surtax:
The amount subject to the surtax is the lesser of their $15,000 in net investment income or the $9,000 excess MAGI ($259,000 − $250,000).
Thus, $9,000 is subject to the surtax.Step 2: Calculate the surtax:
3.8% × $9,000 = $342.Step 3: Marginal tax rate impact:
John and Jane’s stated marginal tax rate is 28%. However, due to the Medicare surtax, their effective marginal tax rate becomes 31.8% (28% + 3.8%).
Impact of Charitable IRA Contributions on Tax Efficiency
If John and Jane reduce their taxable income by $9,000 through a charitable contribution from an IRA withdrawal, they will effectively lower the cost of giving. This is because the surtax is no longer triggered on that income.
Step 1: Compute the reduction in cost:
By reducing taxable income by $9,000, the cost of giving is lowered by 31.8% (the total marginal tax rate including the surtax), as opposed to just the 28% stated rate they would face without the surtax.Step 2: The additional savings:
The reduction in taxable income from a charitable IRA donation effectively reduces the cost of giving by an extra 3.8% (31.8% − 28%) compared to a standard donation using just their stated marginal rate.
By donating via an IRA withdrawal, John and Jane can lower their effective marginal tax rate, reducing the cost of their charitable contribution by more than if they simply made a cash donation and itemized deductions. This highlights the tax efficiency of charitable giving through IRA withdrawals, particularly for those subject to the Medicare surtax.
Taxation of Social Security Benefits and Impact of Charitable IRA Withdrawals
The taxability of Social Security benefits depends on the taxpayer’s “provisional income,” which is the sum of the taxpayer’s Adjusted Gross Income (AGI) (excluding Social Security benefits), foreign earned income, tax-exempt interest, and half of the Social Security benefits. The tax rate on Social Security benefits can be 0%, 50%, or 85%, based on how much the taxpayer’s provisional income exceeds certain thresholds.
For single filers, the thresholds are:
- $25,000: If provisional income is below this amount, no Social Security benefits are taxable.
- $25,000 to $34,000: The taxable portion is the lesser of 50% of Social Security benefits or 50% of the excess provisional income over $25,000.
- Above $34,000: The taxable portion is the lesser of 85% of Social Security benefits or 85% of the excess provisional income over $34,000, plus the lesser of $4,500 or 50% of Social Security benefits.
For married couples filing jointly, the thresholds are:
- $32,000: No benefits are taxable if provisional income is below this amount.
- $32,000 to $44,000: The taxable portion is the lesser of 50% of Social Security benefits or 50% of the excess provisional income over $32,000.
- Above $44,000: The taxable portion is the lesser of 85% of Social Security benefits or 85% of the excess provisional income over $44,000, plus the lesser of $6,000 or 50% of Social Security benefits.
Example 1: Jonathan and Marilyn Cook
Jonathan and Marilyn Cook, who file jointly, have provisional income of $40,000 and Social Security benefits of $25,000. Their provisional income includes $5,000 from IRA withdrawals. Their stated marginal tax rate is 15%.
Step 1: Calculate the taxable Social Security benefits
The taxable portion of their Social Security benefits is the lesser of:- 50% of $25,000 = $12,500, or
- 50% of the excess provisional income over $32,000, which is 50% × ($40,000 − $32,000) = $4,000.
Thus, $4,000 of their Social Security benefits is taxable.
Step 2: Impact of IRA charitable withdrawal
If Jonathan and Marilyn donate $4,000 of the $5,000 IRA withdrawal to charity, their provisional income is reduced to $36,000.
The taxable portion of their Social Security benefits is now the lesser of:- 50% of $25,000 = $12,500, or
- 50% of the excess provisional income over $32,000, which is 50% × ($36,000 − $32,000) = $2,000.
Now, only $2,000 of their Social Security benefits is taxable.
The reduction in taxable Social Security benefits is $4,000 − $2,000 = $2,000.
Step 3: Calculate the tax savings
The total tax savings from the IRA charitable withdrawal is:
($2,000 reduction ÷ $4,000 contribution) × 15% tax rate = 7.5%.
Therefore, the effective cost of giving is reduced by 7.5% due to the reduction in taxable Social Security benefits. Instead of just a 15% tax benefit, the total reduction is 22.5%.
Example 2: Alice Millhouse
Alice Millhouse, a single taxpayer, has provisional income of $65,000 and receives $30,000 in Social Security benefits. Her provisional income includes $15,000 from taxable IRA withdrawals. Her stated tax rate is 25%.
Step 1: Calculate the taxable Social Security benefits
The taxable portion of her Social Security benefits is the lesser of:- 85% of $30,000 = $25,500, or
- 85% of the excess provisional income over $34,000, plus the lesser of $4,500 or 50% of Social Security benefits.
$65,000 − $34,000 = $31,000, so 85% × $31,000 = $26,350. Adding the lesser of $4,500 or 50% of $30,000 = $15,000, we get:
$26,350 + $15,000 = $30,850.
Thus, $25,500 is the taxable portion of her Social Security benefits.
Step 2: Impact of IRA charitable withdrawal
If Alice directs all of the $15,000 IRA withdrawal to charity, her provisional income decreases to $50,000.
The taxable portion of her Social Security benefits is now the lesser of:- 85% of $30,000 = $25,500, or
- 85% of the excess provisional income over $34,000, which is 85% × ($50,000 − $34,000) = $13,600, plus the lesser of $4,500 or 50% of $30,000, which is $15,000.
Thus, the taxable amount is $18,100.
Step 3: Calculate the tax savings
The reduction in taxable Social Security benefits is:
$25,500 − $18,100 = $7,400.
The cost of giving is reduced by:
($7,400 reduction ÷ $15,000 donation) × 25% tax rate = 12.3%.
Therefore, the overall reduction in the cost of giving is 37.3%, as opposed to just the 25% marginal tax rate.
Medicare Premiums and Their Impact on Charitable Giving
Medicare Part B covers a range of outpatient services, including doctor visits, laboratory tests, medical equipment, mental health services, and some ambulance and home health care. Medicare Part D is an optional program that provides prescription drug coverage. Both Medicare Part B and Part D have a standard out-of-pocket premium, but this premium can increase based on a recipient’s Modified Adjusted Gross Income (MAGI), which is calculated as the sum of Adjusted Gross Income (AGI), tax-exempt interest income, and any net foreign income exclusions.
As a taxpayer’s MAGI increases, so do the Medicare premiums they are required to pay. For 2024, the premium increases are phased in at specific income thresholds, which means that the surcharge is applied at single breakpoints rather than gradually over a range.
The Effect of MAGI Reductions on Charitable Giving
One way to reduce MAGI and, consequently, the cost of Medicare premiums is through charitable contributions made directly from IRA withdrawals. These contributions help reduce the taxpayer’s AGI, which could lower their MAGI and potentially bring them below a certain threshold where higher Medicare premiums apply.
- Impact of Charitable IRA Withdrawals on Medicare Premiums:
- If MAGI is reduced through charitable contributions from IRA withdrawals but does not fall below a threshold (breakpoint), the reduction in the cost of giving is similar to making a cash donation and itemizing the deduction. In this case, the tax savings would be based on the taxpayer’s marginal tax rate.
- However, if IRA withdrawals reduce MAGI enough to drop below a breakpoint, the taxpayer not only saves on income taxes but also reduces their Medicare premium surcharge. This can lead to a more significant reduction in the overall cost of charitable giving.
Charitable Giving When Itemizing Deductions
When a taxpayer itemizes deductions, the tax benefit of a cash donation or a charitable contribution made via an IRA withdrawal is typically similar, provided the donation is fully deductible and the IRA withdrawal occurs in a range where there is no loss of tax benefits. However, it is important to note that there will never be a situation where contributing cash and itemizing is more tax-efficient than making the same contribution from IRA withdrawals.
In cases where cash donations are not fully deductible, the reduction in taxable income from an IRA charitable withdrawal may be more tax-efficient. This is particularly true when the taxpayer is unable to maximize itemized deductions, or when the value of their cash contribution is limited by deduction caps or phase-outs based on their income level.
Charitable Giving When Not Itemizing Deductions
For taxpayers who do not itemize their deductions, making an after-tax contribution to charity does not provide a direct tax benefit. Since there is no ability to deduct these contributions, the effective tax rate on the donation is zero, meaning the taxpayer does not receive any reduction in taxable income for the donation.
This situation is common among older taxpayers who no longer have a mortgage on their personal residence, making them less likely to itemize their deductions. As a result, these non-itemizers do not gain any tax benefit from making charitable contributions, and thus, the cost of giving remains the full amount donated.
Charitable Contributions May Be Partially Deductible
In some cases, even when a taxpayer itemizes their deductions, the full value of a charitable contribution may not be deductible. This typically happens when the taxpayer’s total itemized deductions only slightly exceed the standard deduction, limiting the actual benefit derived from the donation.
Example: Taxpayer’s Limited Charitable Deduction
Let’s consider a 75-year-old taxpayer who files as a single individual with a marginal tax rate of 25%. For 2024, she qualifies for a standard deduction of $8,400, which includes an additional $1,650 for being over 65 years old. She donates $5,000 to qualified charities and has a total of $10,000 in itemized deductions.
Step 1: Calculate the excess of itemized deductions over the standard deduction
The taxpayer’s itemized deductions exceed the standard deduction by $10,000 − $8,400 = $1,600.Step 2: Calculate the deductible portion of the charitable contribution
Since her itemized deductions exceed the standard deduction by $1,600, only a portion of her $5,000 charitable contribution will be deductible. The deductible amount of the donation is $1,600.Step 3: Calculate the effective tax benefit
The tax benefit of the charitable contribution is based on the deductible amount of $1,600, not the full $5,000 donation. Therefore, the reduction in her taxable income due to the charitable contribution is:
25% × ($1,600 ÷ $5,000) = 8%.
As a result, the effective cost of giving is reduced by 8%, not the full 25% that would apply if the entire $5,000 were deductible.
Statutory Limits on Charitable Contributions for Itemizers
The IRS places limits on the total amount of charitable contributions that can be deducted in any given year. The maximum allowable deduction for most cash donations is 50% of the taxpayer’s Adjusted Gross Income (AGI). However, for donations of capital gain property, the deduction is capped at 30% of AGI.
Step 1: Charitable Deduction Limits
If a taxpayer makes charitable contributions that exceed these limits, they can carry the excess contributions forward for up to five years. In the year the contribution exceeds the limits, the portion that is not deductible does not reduce the taxpayer’s taxable income, meaning there is no immediate tax benefit for that excess amount.Step 2: Carryforward Option
Although contributions that exceed the limits can be carried forward to future years, the value of these contributions is reduced due to the time value of money. Even assuming constant tax rates, the tax benefit of the carryforward is less than an immediate deduction, as the savings are deferred.
Example: Excess Charitable Contributions and Carryforward
If a taxpayer makes a $20,000 charitable contribution, but their AGI for the year is $30,000, only 50% of their AGI—$15,000—can be deducted in that year. The remaining $5,000 is subject to the 5-year carryforward rule.
Step 1: Calculate the deductible portion
The taxpayer can deduct $15,000 in the current year.Step 2: Calculate the carryforward amount
The remaining $5,000 can be carried forward to future years. The tax benefit on this amount will be realized in future years, but the present value of those benefits is less than if the taxpayer could deduct the full $20,000 in the current year.
Donation of Capital Gain Property to Charity
When it comes to charitable giving, donating capital gain property can often be more tax-efficient than making itemized cash contributions or giving via IRA withdrawals. This is because donations of capital gain property allow the donor to avoid paying taxes on long-term capital gains, while still benefiting from a charitable deduction.
Tax Benefits of Donating Capital Gain Property
Capital gain property, which includes appreciated assets such as real estate, stocks, and other investments held for more than one year, is eligible for a charitable deduction based on its fair market value (FMV) rather than its original purchase price or “basis.” This allows the donor to avoid paying long-term capital gains tax on the appreciation of the property.
For 2024, the tax benefit for donating capital gain property is subject to a 30% AGI limitation, meaning that the total deduction for such contributions cannot exceed 30% of the donor’s Adjusted Gross Income (AGI) in a given year. However, if the donation exceeds this limit, the donor can carry the excess contribution forward for up to five years.
Definition of Capital Gain Property
For charitable giving purposes, capital gain property refers to assets that are considered capital assets or Code Sec. 1231 assets, held for more than one year. If these assets were sold at their fair market value, they would result in long-term capital gains.
Some examples of capital gain property include:
- Stocks
- Bonds
- Real estate (held for investment)
- Collectibles (not related to ordinary income)
However, ordinary income property is excluded from this tax benefit. Ordinary income property refers to assets that, if sold, would not generate long-term capital gains. Instead, these are taxed as ordinary income. Examples include:
- Property held for less than one year
- Inventory
- Works of art, manuscripts, or letters created by the donor
- Certain stocks (under Code Sec. 306)
Additionally, the deduction of basis (instead of FMV) applies if the donated property’s use by the charity is not related to the charity’s tax-exempt purpose. For instance, if the donated property is tangible personal property not used in the charity’s tax-exempt function, the donor can only deduct the property’s basis.
Example: Capital Gain Property Donation
Let’s assume a taxpayer, with an AGI of $100,000, donates appreciated real estate worth $40,000 that has a basis of $10,000. If the property were sold, the taxpayer would realize a long-term capital gain of $30,000 ($40,000 FMV − $10,000 basis). By donating the property directly to a qualified charity:
Step 1: Determine the Deduction
The taxpayer can deduct the full fair market value of the property, $40,000, rather than just the basis of $10,000, and avoid the capital gains tax on the $30,000 appreciation.Step 2: Apply the 30% AGI Limit
Since the donation is considered capital gain property, it is subject to the 30% AGI limitation. The maximum allowable deduction is 30% of $100,000 AGI = $30,000.Step 3: Carry Forward Excess Contributions
If the taxpayer had more than $30,000 in capital gain property donations, the excess can be carried forward to future years, up to five years.
Advantages of Donating Capital Gain Property
- Avoidance of Capital Gains Tax: The donor avoids paying capital gains tax on the appreciated value of the property, which can result in substantial tax savings.
- Larger Charitable Deduction: Donating appreciated assets allows the taxpayer to deduct the fair market value, which can be much larger than the basis of the property.
- Reduced Taxable Income: The deduction helps reduce the donor’s taxable income, lowering the overall tax liability.
Reduction in Cost of Charitable Giving When Donating Capital Gain Property
When a taxpayer donates capital gain property to a charity and itemizes their deductions, the reduction in the cost of giving is determined by both the ordinary income tax rate and the long-term capital gains tax rate, applied to the appreciation of the asset relative to its fair market value. This combination of tax rates helps the donor reduce the overall cost of the contribution.
Example 1: James and Susan Jeffries
James and Susan Jeffries, who itemize their deductions, donate stock that has appreciated in value. Their ordinary tax rate is 28%, and their long-term capital gains rate is 15%. The stock they donate has a fair market value of $5,000 and a basis (original purchase price) of $2,000. The reduction in the cost of giving is calculated as follows:
Step 1: Determine the appreciation of the stock
The appreciation is the difference between the fair market value and the basis:
$5,000 (FMV) − $2,000 (basis) = $3,000 appreciation.Step 2: Calculate the capital gains tax savings
The capital gain portion of the donation is subject to a 15% tax, so the tax savings are:
($3,000 ÷ $5,000) × 15% = 9%.Step 3: Add ordinary income tax rate
The ordinary income tax rate of 28% applies to the full value of the donation, resulting in an additional 28% tax benefit.Step 4: Calculate the total reduction in cost
The total reduction in the cost of giving is the sum of the ordinary income tax rate (28%) and the capital gains tax savings (9%), which results in a 37% total reduction.
Example 2: Table of Reduction in Cost Based on Capital Gain Appreciation
The following table shows how the appreciation of the capital gain property impacts the reduction in the cost of giving. Assuming the taxpayer has a 15% long-term capital gains rate, the table illustrates the tax savings as the appreciation increases:
| Appreciation (%) | Reduction in Cost of Giving |
|---|---|
| 100% (Basis = $0) | 15% (Capital gain tax rate) |
| 50% | 7.5% (15% × 50%) |
| 0% (Basis = FMV) | 0% (No reduction, like a cash donation) |
The greater the appreciation of the asset relative to its fair market value, the greater the tax savings from the donation. If the property has appreciated significantly (e.g., 100% or more), the donor benefits more from the avoidance of capital gains taxes.
Impact of Donating vs. Passing Assets to Heirs
If a taxpayer intends to pass appreciated capital assets to heirs rather than donating them to charity, the heirs typically receive a step-up in basis to the fair market value at the date of the decedent’s death. This means the heirs will not have to pay taxes on the unrealized capital gains. The tax benefit of avoiding capital gains is similar whether the asset is donated to charity or passed to heirs. However, if the taxpayer is planning to pass the asset to heirs, the reduction in the cost of giving capital gain property should be considered more carefully, as it could be less beneficial than donating the asset, depending on other factors such as estate planning goals.
When Should You Choose Cash Contributions for Charitable Giving?
Cash contributions are a common method of charitable giving, but they are generally not as tax-efficient as other alternatives such as IRA withdrawals or donating capital gain property. While there are some scenarios where cash contributions can have similar tax benefits to these other methods, they rarely provide a more favorable tax outcome.
Comparing Cash Contributions to Other Giving Methods
Cash vs. Capital Gain Property Donations
Cash contributions are only as tax-efficient as donating capital gain property when the appreciated capital gain asset has no gain (i.e., when the fair market value is equal to the basis) or when the taxpayer’s capital gains tax rate is zero. In most cases, however, donating appreciated capital gain property provides more tax benefits because the donor can avoid paying taxes on the capital gains.Cash vs. IRA Withdrawals
Cash contributions are also only as tax-efficient as IRA withdrawals in very specific situations. This occurs when the reduction in taxable income from IRA withdrawals does not trigger the reduction of additional tax charges, such as moving the taxpayer into a higher tax bracket. Otherwise, charitable IRA withdrawals can offer greater tax advantages, especially for those who are required to take Required Minimum Distributions (RMDs) and wish to donate the funds to charity.
Why Cash Contributions May Not Be the Best Choice
While cash contributions are straightforward, they are rarely more tax-efficient than donating capital gain property or making IRA withdrawals. These other methods allow the donor to avoid paying taxes on capital gains or reduce taxable income, resulting in a greater reduction in overall tax liability.
However, cash contributions may still be the best option for many taxpayers due to the following reasons:
IRA Withdrawals: Gifting IRA withdrawals to charity is only available to individuals aged 70.5 or older who have sufficient funds from their Required Minimum Distributions (RMDs) to donate. Many taxpayers may not be in this position or may not want to donate all or part of their IRA withdrawals.
Capital Gain Property: Donating appreciated capital gain property, such as stocks, can provide significant tax benefits. However, this option is only available to those who own such assets and are not planning to pass them on to heirs. Additionally, there are restrictions on what types of capital gain property qualify for full market value deductions.
Gifting Capital Gain Property vs. IRA Withdrawals for Upper-Income Taxpayers
For upper-income taxpayers who are considering charitable giving, the choice between donating capital gain property and making charitable contributions from IRA withdrawals depends on several factors, including the taxpayer’s age, the amount of capital gain property appreciated, and whether the taxpayer itemizes deductions.
When to Choose Capital Gain Property Donations
If a taxpayer owns capital gain property that has appreciated significantly and is not planning to pass it on to heirs, donating this property to charity is generally the best option, provided the taxpayer itemizes their deductions. When capital gain property is donated, the taxpayer can deduct the fair market value of the asset and avoid paying capital gains taxes on the appreciation, making this method highly tax-efficient.
When to Consider IRA Withdrawals for Charity
If the taxpayer is at least 70.5 years old and has surplus IRA withdrawals available, contributing through IRA withdrawals may be another option. However, when choosing between donating capital gain property and making charitable contributions from IRA withdrawals, a detailed analysis is needed to determine which method results in the lowest overall cost of giving. For taxpayers who do not itemize deductions, IRA withdrawals are typically the better option for charitable giving.
Factors Influencing the Decision: Capital Gain Property vs. IRA Withdrawals
Capital Gain Rate
For upper-income taxpayers, who are often subject to a 15% or higher long-term capital gains tax rate, donating capital gain property is likely to be more tax-efficient. This is because the taxpayer can avoid paying taxes on the appreciation in value of the asset.Impact of MAGI on Additional Tax Costs
If the taxpayer’s charitable contribution through IRA withdrawals results in a reduction of their Modified Adjusted Gross Income (MAGI), it could help lower their Medicare premiums or reduce other tax liabilities, such as phase-outs of deductions or exemptions. This is a key consideration when the taxpayer’s MAGI is near a breakpoint for higher Medicare premiums or the phase-out of itemized deductions.Medicare Surtax and Capital Gain Property
The Medicare surtax of 3.8% applies to the lesser of a taxpayer’s net investment income or their MAGI over certain thresholds ($250,000 for joint filers, $200,000 for single filers). If the taxpayer’s net investment income is sufficiently high, the 3.8% surtax may be applied on top of other taxes. In this case, IRA withdrawals might become more attractive, particularly if the capital gain property has less than 40% appreciation relative to its fair market value.When IRA Withdrawals Are Preferable
If the appreciation of the capital gain property is modest (less than 50%) and the taxpayer’s capital gain tax rate is 15% or more, the decision is not as clear-cut. At this point, tax considerations related to the phase-out of exemptions and itemized deductions come into play, which could affect the total cost of giving. Charitable contributions made through IRA withdrawals may provide a greater benefit if they help reduce AGI, lowering the taxpayer’s tax burden and potentially avoiding other tax surcharges.- If the appreciation of the capital gain property is less than 20% of the fair market value, IRA withdrawals are often the better choice, especially if the taxpayer is subject to the Medicare surtax or if the exemption and itemized deduction phase-outs are already in effect.
For upper-income taxpayers, gifting capital gain property is typically more tax-efficient than making IRA withdrawals, especially when the asset has appreciated significantly. However, in certain cases, such as when the taxpayer’s MAGI is near a breakpoint for Medicare premiums or when the appreciation of the capital gain property is relatively modest, charitable IRA withdrawals can offer substantial tax savings. The decision between these two methods should be made based on a careful analysis of the taxpayer’s specific situation, considering factors like MAGI, capital gain appreciation, and the impact of tax surcharges like the Medicare surtax.
Gifting Capital Gain Property vs. IRA Withdrawals for Lower and Middle-Income Taxpayers
For lower and middle-income taxpayers who are at least 70.5 years old, the primary consideration when deciding between donating capital gain property or making charitable contributions via IRA withdrawals is often the impact on taxable Social Security benefits. As a taxpayer’s AGI (Adjusted Gross Income) increases, a larger portion of their Social Security benefits may become taxable, which is a common additional tax cost for these groups.
Lower-Income Taxpayers:
Capital Gain Tax Rate: Lower-income taxpayers often fall into the 0% long-term capital gain tax rate bracket, meaning they will not pay taxes on capital gains from appreciated property. Additionally, many lower-income taxpayers will not have any Social Security benefits taxed, which makes capital gain property donations a highly tax-efficient option.
Choice Between IRA Withdrawals and Capital Gain Property: Since lower-income taxpayers usually pay no capital gains tax, donating appreciated capital gain property to charity will provide them with the full deduction for the property’s fair market value without triggering any additional taxes. Thus, for these taxpayers, donating capital gain property is typically more tax-efficient than IRA withdrawals, which would only be beneficial if they had RMDs (Required Minimum Distributions) and wanted to reduce their taxable income.
Middle-Income Taxpayers:
Capital Gain Tax Rate: Middle-income taxpayers are generally subject to a 15% long-term capital gain tax rate and often have some of their Social Security benefits taxed as their AGI increases.
Social Security Taxation: The taxable portion of Social Security benefits increases as AGI rises, making it an important consideration for middle-income taxpayers when deciding between IRA withdrawals and donating capital gain property. For these taxpayers, the decision hinges on the extent to which the appreciated capital gain property reduces their taxable income compared to the impact of charitable IRA withdrawals in reducing taxable Social Security benefits.
Example Scenarios:
Example 1: Modest Capital Gain Property Appreciation
For middle-income taxpayers with modest capital gain property appreciation, such as a 50% increase in value, the decision can be less clear. In this case, the tax savings from donating capital gain property may not be as substantial. If the appreciation is less than 50% and the taxpayer’s Social Security benefits are taxed, a more thorough analysis is needed to compare the potential tax reduction from IRA withdrawals (which may lower taxable Social Security benefits) against the avoidance of capital gains tax through a property donation.Example 2: Significant Capital Gain Property Appreciation
When the capital gain property has appreciated significantly (e.g., 100% of the property’s value), donating it may be more tax-efficient. In such cases, the taxpayer avoids paying capital gains tax on the appreciation, and the tax deduction from the property’s full fair market value provides a greater benefit compared to IRA withdrawals.- Example: In Example 6, donating appreciated capital gain property could reduce the cost of giving by 7.5%, while in Example 7, the reduction in cost increases to 12.5%. These examples demonstrate that as the appreciation of the property increases, the tax benefit from donating capital gain property grows, making it the more advantageous option.
Decision Process:
Ultimately, the best approach for lower and middle-income taxpayers will depend on the degree of appreciation of the capital gain property and the effect of charitable contributions on reducing taxable Social Security benefits. If capital gain property is significantly appreciated, it is often the better choice for charitable giving. However, if the appreciation is modest, it’s essential to analyze whether the tax reduction from reducing taxable Social Security benefits through IRA withdrawals provides a greater overall benefit.
A personalized analysis should be conducted to compare the tax savings from contributing IRA withdrawals (which can reduce taxable Social Security benefits) with the avoidance of capital gains taxes through capital gain property donations.
Conclusion
Taxpayers who are interested in charitable giving should focus on making contributions in the most tax-efficient manner. Tax efficiency can be measured by how much the cost of giving is reduced compared to making a nondeductible after-tax cash contribution. With the law now permanently allowing nontaxable charitable distributions from IRA withdrawals (up to $100,000 for taxpayers aged 70.5 or older), taxpayers should carefully evaluate this option alongside cash donations and contributions of capital gain property to determine which method results in the lowest overall cost of giving.
While cash donations will never be the most tax-efficient choice compared to IRA withdrawals or capital gain property contributions, they remain a practical option for many. For taxpayers who cannot take advantage of IRA withdrawals or capital gain property donations, cash contributions provide a simple and accessible method of giving.
When comparing capital gain property donations to IRA withdrawals, the most tax-efficient method is usually donating highly appreciated capital gain property. However, for less appreciated capital gain property, a more detailed analysis is needed to decide which option provides the greatest tax savings. By carefully considering the potential tax benefits of each contribution type, taxpayers can make informed decisions that maximize their charitable impact while minimizing the tax cost.
We provide seamless solutions to Small and Medium Businesses. Whatever work you do, we can help.