The new tax law, the Tax Cuts and Jobs Act (TCJA), made a few changes that affect, both directly and indirectly, the well-known charitable donation tax deduction. Two of the most significant changes affecting the deduction of charitable donations are the increased standard deduction and the limit on the deduction of state and local taxes (SALT). Why do these two changes affect charitable deductions so strongly? First, let’s get a little background (if you’re already comfortable with the background info, skip ahead for suggestions on how to maximize your charitable deductions and tax savings under the new law).
Standard vs. Itemized Deductions
As a taxpayer, you have the option to itemize your deductions or to take the standard deduction. Whichever you choose will decrease your taxable income and will therefore (generally) decrease your tax liability. That said, it makes sense that taxpayers will opt to take whichever is higher and therefore helps them reduce their tax bill by as much as possible. But what are they?
- The Standard Deduction – The tax code allows every taxpayer to deduct a standardized amount, basically just for breathing. Prior to the new tax law, the standard deduction was $6,350 for single taxpayers and $12,700 for married taxpayers. For 2018, the standard deduction is nearly double what it was prior to the change, with single taxpayers getting a standard deduction of $12,000 and married taxpayers getting a standard deduction of $24,000 (plus an additional $1,300 for taxpayers over 65)
- Itemized Deductions – The total of all of the various types of deductions that the tax code allows. Examples of types of itemized deductions include:
- State and local taxes, including real estate taxes (now capped at $10,000 thanks to the TCJA)
- Interest expense including mortgage and investment interest (subject to limitations)
- Charitable donations
- Deductible medical expenses
If the aggregate total of your itemized deductions exceeds the standard deduction to which you are entitled, you will deduct that itemized total, if the standard deduction is larger, then you will deduct the standard amount.
Capping the SALT Deduction
The TCJA put a cap on the amount of state and local taxes (which includes real estate taxes) that can be deducted in a given year. For single and married taxpayers who file joint returns, the maximum deduction is $10,000 (for married taxpayers filing separately the max is $5,000).
Why is this relevant to the charitable deduction?
This is relevant because a higher standard deduction and a cap on the SALT deduction means that it is less likely that you will opt to itemize your deductions (because it is less likely that the itemized total will exceed the standard deduction). While it’s still generous to make a charitable contribution if you are not itemizing, you won’t actually get any of the tax savings that you may have been used to getting in the past. Let’s use the following facts for an example:
- You are married and file a joint tax return with your spouse
- Your state and local income taxes are $12,000
- Your real estate taxes are $6,000
- Your mortgage interest is 4,000
- Your deductible medical expenses are $0
Under the Old Rules
- Your total itemized deductions equal $22,000
- On December 31st you are ready to make donations to your favorite charities and decide that you would like to donate $2,000
- You know that you’ve already exceeded the (old) standard deduction of $12,700, so for every additional dollar that you donate to charity, you will increase your total itemized deductions. If your tax rate is 30%, every dollar you donate to charity will save you thirty cents
Under the New Rules
- Your state and local taxes, plus your real estate taxes, are limited to a maximum deduction of $10,000.
- Your total itemized deductions equal $14,000 ($10,000 of SALT + $4,000 of mortgage interest)
- On December 31st you are ready to make donations to your favorite charities
- You know that, before making your donations, you have not yet exceeded the new standard deduction of $24,000. This means that, until your total itemized deductions exceed the standard deduction, you won’t get any tax benefit from making these donations
- Why not? Because if you donate $2,000, your total itemized deductions will be $16,000, and you will still opt to take the higher standard deduction of $24,000 (which you were entitled to whether you made the donations or not)
Instead of the $2,000 donation saving you $600 of taxes ($2,000 x 30%) like they would have under the old rules. Under the new rules, they will not decrease your taxes at all because each dollar donated to charity does not affect your total deduction, which is still $24,000 (the standard deduction). Unless you make a large enough donation that your total itemized deductions exceed $24,000 (which is not in the budget for many taxpayers), you won’t see any tax savings from making charitable contributions.
What strategies can you employ to get some tax savings from making charitable donations under the new tax rules?
There are a few strategies that you can use to help capture some of the tax savings that you may have enjoyed under the old tax law:
Group Charitable Donations Every Other Year
Instead of making donations to your favorite charities every year, donate twice as much, but only donate every other year. This way, you’re making the same contributions to the same charities, but by timing the donations slightly differently you can maximize the chance of getting some benefit of the contributions. Why does this work? Let’s take a simpler example:
- You are married and file a joint tax return with your spouse
- Your state and local tax deduction is capped at $10,000
- You don’t have any mortgage interest, deductible medical expenses or other itemizable deductions
- You want to donate $10,000 per year to charitable organizations
Without grouping your donations, you will end up with $20,000 of itemized deductions every year and will therefore opt to take the $24,000 standard deduction instead. Your total deductions in the 2-year window will be $48,000 ($24,000 in each year)
However, if you group your donations every other year, in odd years you will have $10,000 of itemized deductions (and will therefore take the higher $24,000 standard deduction), and in even years you will have $30,000 of itemized deductions ($10,000 of SALT + $20,000 of donations) and will therefore take the higher itemized total of $30,000. Your total deductions will now be $54,000 ($24,000 in year 1 + $30,000 in year 2). At a tax rate of 30%, this would save you $1,800 ($6,000 of additional deductions x 30%)
Make Qualified Charitable Donations (QCDs) from Your IRA
Normally, when you take distributions out of your IRA (once you’ve retired), the funds are taxable to you at your ordinary tax rate. However, if instead of taking distributions for yourself, you decide to use the distribution to make a QCD, the distribution will not be taxable. This is especially valuable because any taxpayer over 70 ½ is required to take distributions from their IRA annually (these distributions are called Required Minimum Distributions, or RMDs).
If you are in situation where you are required to take RMDs but find that you don’t really need the money, you can instead use the funds to make charitable donations. This is particularly beneficial under the new tax law because, unlike normal charitable donations, QCDs are not itemized deductions. QCDs decrease your income from your IRA directly and immediately, without requiring that you exceed the standard deduction before seeing any benefit from the donations. This means that even if your aggregate itemized distributions are very low, you can still save on taxes by making QCDs.
In order to make a QCD, the following criteria must be met:
- You must be 70 ½ or older
- It must be distributed from an IRA
- It must meet standard tax-law requirements for a 100% deductible charitable contribution. This means that if you get any value back from your donation that might require that a portion of the donation be non-deductible (e.g. tickets to a concert or a fancy dinner), the donation does not qualify as a QCD
- The IRA distribution must otherwise be taxable
- You cannot make more than $100,000 in QCDs in a given year (married spouses with their own IRAs can make QCDs of $100,000 each)
The tax benefits of making a QCD
- QCDs are excluded from AGI, and a lower AGI is good for keeping taxes low
- QCDs count as your RMD from your IRA, so you don’t have to take a taxable distribution from your IRA for the portion that you used for the QCD
- If your IRA balance is partially taxable and partially non-taxable, the QCD will wipe out the taxable portion first
While QCDs aren’t for everyone, if you fit the mold they can be a great strategy for reducing your tax bill while still making the charitable donations that your used to.
Not sure if these strategies are right for you? Unsure about something you read? Give us a call, we can help!
Disclaimer: The topics discussed in this article cover complex tax law. You should always consult your tax advisor before making any tax-planning decisions.