A simple hypothetical example illustrates the value of being tax savvy when making donations. Suppose an individual in the 35% tax bracket makes a $100,000 donation to a qualified charitable organization. The donation will qualify as a deduction and save the individual $35,000 in taxes. After factoring in tax savings, the charitable gesture will cost only $65,000.
If securities are to be used to fund charitable donations, however, the treatment of capital gains must also be considered. In some cases, charities can accept securities as donations, which prevents donors from having to sell the securities and realize taxable capital gains.
In other instances, however, charities will not accept securities. In such cases, a donor’s first impulse may be to liquidate holdings to raise cash for their donations. In the above scenario, however, if the $100,000 includes $40,000 in capital gains, the donor would have to pay the IRS $6,000 when liquidating the holdings assuming a capital gains tax rate of $15%.
To avoid capital gains taxes, the use of a donor-advised fund may be appropriate. Such funds will typically accept securities as donations and then liquidate the positions in order to pass cash on to charitable organizations, thereby preventing investors from having to sell securities and pay capital gains taxes. Investors can also recommend which charities receive the assets from the donor-advised funds.
Advisor may also recommend that clients with sizeable assets establish trusts for tax planning and charitable giving. For example, with a charitable remainder trust, a beneficiary can receive income from trust assets for his or her lifetime or during a specified number of years.
At the end of the time period, the remaining assets are then donated to a specified charity. Investors receive a tax donation based on the present value of the remaining assets that will be given to charities. Also, the trust is exempt from taxes generated by investment holdings.
Advisors should also help their clients determine how the timing of making donations will impact tax savings. For example, clients may want to target donations for years in which they expect their taxes to increase. Tax increases can result from a variety of developments, including increases in salaries, making withdrawals from 401(k) plans, and converting traditional IRAs to Roth IRAs.
More specifically, when making an IRA conversion, the money transferred into the Roth IRA is included in an investor’s salary, which can put the investor in a higher tax bracket. Assets rolled from the regular IRA to Roth IRA, furthermore, are taxed at the owner’s income tax rate. With that in mind, it may make sense to maximize charitable donations in years when IRAs are being converted to Roth accounts or when withdrawals from 401(k) plans are being made.
In addition to maximizing tax benefits, most investors will want to ensure that their donations have the maximum potential for contributing to the greater good. In other words, they want to ensure that their donations are going to charities that don’t waste assets on high administrative fees and excessive salaries.
Advisors can help clients with that goal by referring them to services that research charitable organizations. They include CharityNavigator, CharityWatch and GuideStar. Advisors should also ensure that clients are selecting organizations that have tax exempt status with the IRS. The status can be determined by reviewing 990 forms on organizations’ websites.