The Rich Life Blog

Tax Deductions part 2

Posted by Lisa Lawhorn

October 16, 2018

Tax Deductions: Part 2

On September 25, 2018, we posted a blog written by Jason Hass regarding changes to tax law resulting from the passage of the Tax Cuts and Jobs Act (TCJA).  In his post, Jason described the changes to itemized deductions. This post is a continuation of that subject with a focus on some strategies to maximize the tax benefits of charitable contributions.

Every year, you compare your actual deductions to the standard deduction and deduct whichever is higher. One of the more significant changes to tax law resulting from the TCJA is the doubling of the standard deduction. In fact, estimates have stated that only 10% of all taxpayers will itemize their deductions starting in 2018, down from 30% prior to the new tax law being passed. As a result, a strategy that some may want to consider utilizing is the deduction for charitable gifts every other year. This is also known as ‘Bunching’.

Bunching:

Under this strategy, a person would bunch their charitable contributions ever other year, thus alternating between taking the standard deduction and itemizing their deductions.

Base Scenario:

Married filing joint, taxpayer, 42, and spouse, 39, with adjusted gross income of $250,000 and expenses as follows: real estate and state income taxes ($18,000), mortgage interest ($5000), and charitable contributions ($12,000).  Using the new tax tables, they are in a 24% tax bracket.

2018
Example 1
INCOME AGI  $  250,000
EXPENSES Real estate & state income taxes  $   10,000 (Deduction limit $10k)
Mortgage interest  $      5,000
Charitable contributions  $    12,000
Total itemized deductions  $   27,000
Standard deduction  $    24,000
Taxable income  $  223,000
Income tax  $    42,099

 

In this example, we see the taxpayers donated $12,000 to charity, but due to the increased standard deduction, this donation only benefitted them by $3,000 in additional deductions ($27,000 – $24,000).  They would be able to take the $24,000 standard deduction even if they gave nothing to charity.

Bunching Scenario:

However, what if the same couple gives $23,000 to charity in 2018, with the intentions of cutting back on their contributions for 2019 and taking the standard deduction.  As you can see, the $23,000 contribution creates an additional deductible amount of $14,000 ($38,000 – $24,000).

2018
Example 2
INCOME AGI  $  250,000
EXPENSES Real estate & state income taxes  $    10,000 Deduction limit 10k
Mortgage interest  $      5,000
Charitable contributions  $    23,000
Total itemized deductions  $   38,000
Standard deduction  $    24,000
Taxable income  $  212,000
Income tax  $    39,459

 

Then, those taxpayers decide to give a minimal amount to charity in 2019 ($1000).  They receive no tax benefit from the charitable donation in 2019, due to the higher standard deduction.  They will plan to give the same amount in 2020 as they did in 2018, thus itemizing their deductions every other year to maximize the benefit of charitable contributions.

2019
Example 3
INCOME AGI  $  250,000
EXPENSES Real estate & state income taxes  $    10,000 Deduction limited to $10,000
Mortgage interest  $      5,000
Charitable contributions  $      1,000
Total itemized deductions  $    16,000
Standard deduction  $   24,000
Taxable income  $  226,000
Income tax  $    42,819

 

From example 1, you can see this couple would receive a $3,000 additional deduction annually by donating $12,000 per year to charity. But by bunching the 2018 and 2019 annual contributions mostly in 2018, the taxpayers contribute the same amount overall, but they created a $13,000 additional deduction in 2018.  The graph below shows how this strategy might play out over a three year period:

 

2018 Total Deductions from income 2019 Total Deductions from income 2020 Total Deductions from income 3-Year Total Deductions from income
Base Scenario $24,000 $24,000 $24,000 $72,000
Bunching Strategy $38,000 $24,000 $38,000 $100,000

 

Keep in mind that itemized deductions benefit tax payers in higher brackets more than those in lower tax brackets.  Our taxpayers above are in a 24% tax bracket, so every additional $1000 given to charity would save them $240 in taxes.

Donor Advised Funds (DAF):

Another tool for managing your charitable donations is a Donor Advised Fund (DAF).

Let’s say our taxpayers above received a large bonus or inheritance in 2018. The couple would like to set aside some of this money to fund future charitable contributions. They plan to keep their giving level at $12,000 per year.  In 2018, in addition to their planned donations of $12,000, they could take $24,000 of that windfall and make a charitable contribution to a Donor Advised Fund.

They would deduct $36,000 in 2018 (their annual giving amount of $12,000 plus the $24,000 gifted to the DAF). In 2019 and 2020, they would instruct the custodian of their DAF to distribute $12,000 annually to the charities of their choice.  They would take the standard deduction in 2019 and 2020.  They essentially “pre-funded” their charitable donations in 2018 and realize all the tax benefit that year.

 

 

2018 Total Deductions from income 2019 Total Deductions from income 2020 Total Deductions from income 3-Year Total Deductions from income
Base Scenario $24,000 $24,000 $24,000 $72,000
Bunching Strategy $36,000 $24,000 $24,000 $84,000

 

Qualified Charitable Contributions (QCDs):

For clients over 70 ½ that will not itemize due to the higher standard deduction, they have an additional option for donating to charity.  The IRS requires taxpayers over age 70 ½ to take a required minimum distribution from their IRAs each year.

This forces taxable income onto the tax return, whether the client needs the money or not.  Utilizing a Qualified Charitable Distribution (QCD) would reduce the taxpayer’s taxable income.  Let’s suppose the taxpayer is a single woman, age 72, with a minimum required distribution amount of $10,000.  She has no earned income and she rents an apartment, so she has no mortgage interest or property taxes to deduct.  Donating $10,000 to charity from cash would yield her no tax benefit, since her standard deduction is $13,600 (she receives an additional deduction of $1600 for being over 65).

However, she can direct her IRA custodian to send her $10,000 minimum required distribution directly to a charity.  In this scenario, she would not get a deduction, but she avoids adding $10,000 to her taxable income on her tax return.  Since many states base their income tax on federal adjusted gross income, she likely would be able to exclude the $10,000 from state income tax too!

Donating to charity certainly yields more benefits than just tax savings but implementing these strategies can help you keep more of your money and donate it to the charity of your choice. If you have any questions about gifting strategies for your unique circumstances, feel free to contact us.

 

Lisa Lawhorn is a Tax Advisor at Wealthquest, a Cincinnati-based financial planning and wealth management firm that offers a full range of financial services under one roof, for one simple fee.



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