Making charitable donations is a high priority for many individuals and families. Doing so enables them to financially support charitable organizations and causes they believe in and may lower their income taxes.
Under current tax law, donations made to qualified charitable organizations — also known as 501(c)(3) organizations — may be tax-deductible during the year in which they’re made. To deduct these contributions, you must itemize deductions on Schedule A (Form 1040) instead of claiming the standard deduction.
A different strategy for giving
If you typically make charitable donations via cash or check, you might be able to increase your tax savings by rethinking your giving strategy. This involves donating property that has appreciated in value and that you’ve held for more than one year to the charity of your choice, instead of giving the charity cash. Usually, such property takes the form of publicly traded stocks or securities.
Appreciated securities you’ve owned for more than one year are considered to be long-term capital gains property. If you sell the securities and realize the gain, you could be liable for paying capital gains taxes at a rate of 15% or 20% on the appreciated value of the stock. You also might have to pay an additional 3.8% net investment income tax (NIIT) on the gain if your modified adjusted gross income (MAGI) exceeds certain thresholds.
But, if you donate the stock to charity, you won’t owe capital gains taxes or the NIIT on the stock’s appreciation. And the charity will receive the full fair market value of the security at the time the donation is made.
What you could save
An example helps illustrate how much money you could potentially save via this strategy. Let’s say you paid $3,000 for a stock five years ago and today the stock is worth $10,000. And let’s assume you’re currently in the 39.6% tax bracket and subject to the top capital gains tax rate of 20% as well as the 3.8% NIIT.
If you sold the stock, you would only have $8,334 after paying capital gains taxes and the NIIT. If you’re also subject to state income tax, the amount you’d have left to give to the charity would be even less. But if you donate the stock to your favorite charity, the charity will be able to receive the full $10,000 value — or at least $1,666 more than if you sold the stock and donated the proceeds to the charity.
Meanwhile, you’ll realize a total savings of $5,626 in federal income taxes. This consists of $3,960 from the charitable donation itself and another $1,666 in capital gains tax and NIIT savings. If you had sold the stock and donated the proceeds net of your income tax liability, your charitable contribution of $8,334 would have yielded a federal tax deduction of just $3,300.
Keep in mind that donations of long-term capital gains property to public charities are subject to deduction limits of 30% of MAGI, compared to 50% of MAGI for cash donations to public charities.
Potential impact of tax reform
It’s worth noting that, during his presidential campaign, Donald Trump proposed capping itemized deductions and eliminating the NIIT. If these tax reforms are eventually enacted, they may have an impact on this strategy, though the game plan wouldn’t necessarily be invalidated.
Consult with your tax advisor to discuss this and other tax-reduction strategies in detail.