A priority for many families who have been financially successful is creating an impact in the world around them and leaving a legacy in areas they are passionate about. This manifests itself in many ways including charitable giving.
When our clients express an interest in making charitable donations, it becomes our responsibility to determine the most tax effective and administratively efficient way to make the gifts.
Most charitable individuals generally have a one or more charities that they want to support consistently. Often the default becomes giving cash each month, quarter, or year to meet the needs of the charitable organization.
From a tax perspective, giving cash directly to the charity on an annual basis is typically the least effective way to fulfill these gifts. This article will focus on a strategy called “Charitable Bunching” and will cover the tax benefits as well as how to implement this strategy in a way that avoids any inconvenience for the charities supported.
Brief Tax Review – How Charitable Deductions Work:
Before discussing charitable bunching, it is important to cover a basic personal income tax concept, the standard deduction versus the itemized deduction.
Every person who files their tax return, is allowed to reduce their income by either the standard deduction, which is available to everyone, or their itemized deductions, which are unique to them. If their itemized deductions are greater than the standard deduction, they benefit by itemizing their deductions.
Key Takeaway:
Taxpayers are allowed to deduct the greater of the standard deduction or their itemized deductions when computing their taxable income.
The typical itemized deductions are medical expenses (but only the portion that exceeds 7.5% of the taxpayer’s adjusted gross income), state and local taxes (but only up to a maximum of $10,000 ), mortgage interest, and charitable contributions.
For 2022, the standard deduction for a married couple under age 65 filing a joint tax return is $25,900; so before a married couple would itemize, they would need to have itemized deductions that exceed $25,900. If they don’t, they will take the standard deduction and their itemized deductions provide no additional tax benefit. The following table demonstrates this concept.
Let’s create an example and look closer at the main itemized deductions. In our example we will assume that a married couple has the following non-charitable itemized deductions:
- Medical Expenses: In most years individuals don’t have medical expenses exceeding 7.5% of their income; so we’ll assume this line is $0.
- State and Local Taxes: State and local taxes included as itemized deductions cannot exceed $10,000 annually; so we’ll assume that between state income taxes and property taxes our couple has reached the $10,000 limit.
- Mortgage Interest: We’ll assume this married couple has a $200,000 mortgage at 3% interest which results in $6k of mortgage interest expense.
Adding these up, this married couple currently has total itemized deductions of $16k which is below the standard deduction of $25,900. In order to itemize, they would need more than $9,900 of charitable contributions before they would exceed the standard deduction.
In other words even if their annual charitable contributions were $10,000, the first $9,900 of their annual contributions provides no tax benefit as the first $9,900 of contributions simply serve to increase the married couple’s itemized deductions to the level of their standard deduction. This concept is demonstrated in the following graphic.
The benefit of bunching charitable contributions is that instead of making annual contributions to charity, charitable contributions are bunched into specific years. For example, charitable bunching would entail making a large gift to charity every two or every three years rather than contributing annually.
By doing this, it is more likely that the charitable contributions will result in itemized deductions exceeding the standard deduction in bunching years.
Key Takeaway:
Taxpayers who bunch their charitable deductions often can increase the tax benefits they receive from their charitable contributions.
Using the example above, bunching results in more deductions over a three-year giving cycle because all contributions in the bunching year that exceed $9,900 receive a tax benefit.
Contrast this with annual giving where the tax benefit of the first $9,900 of charitable gifts would be lost every year since these gifts simply would be increasing the taxpayer’s itemized deductions to the level of the standard deduction that they were already eligible to claim.
How Much Can This Save in Taxes?
Using the numbers from our example above, let’s review the benefits of bunching over a three-year period assuming the couple in our example plans to give $10,000 annually or $30,000 over the three-year period to charity.
As the example shows, this couple gave the same $30,000 to charity over the three-year period in both cases, but by bunching their charitable gifts in 2022 as shown in the case on the right, they were able to increase their total tax deductions by $19,800 over the course of three years.
If this couple is in the 37% federal tax bracket and 2.9% state tax bracket, they would save $7,900 in federal and state income taxes by implementing a bunching strategy over the three-year period.
What If My Charity Needs Annual Funding?
Most individuals who choose to support a charity plan to do so on a recurring basis. Accordingly, the idea of making a large gift one year and none the next leaves them concerned about how such an approach would affect the charity. The good news is that this strategy can be implemented with no impact to the charity.
The best way to implement this strategy is by utilizing a donor-advised fund. We will have a separate article on donor advised funds in the future to cover all their important benefits; however, for purposes of this article the important fact to understand is that a donor advised fund is a charitable account that is similar to a brokerage account or bank account that is earmarked for charitable giving.
Contributions can be made to the donor advised fund at any time. When contributions are made, they are legally an irrevocable charitable gift and count as a charitable contribution on the taxpayer’s tax return.
The donor advised fund then holds the contributed amounts until the taxpayer directs the funds to the charities they would like to support in current or future years.
Using a donor advised fund significantly improves a taxpayer’s ability to implement the charitable bunching strategy because it allows the taxpayer to make the charitable bunching gift to the donor advised fund and qualify for the tax deduction immediately.
Then the taxpayer can use the donor advised fund to support their desired charities on a recurring basis each year. The taxpayer receives the benefit of the bunching strategy and the charity receives recurring funding as needed.
Key Takeaway:
A charitable bunching strategy can be easily implemented with no impact on the charitable organizations you support by using a donor advised fund.
How to Fund a Charitable Bunching Strategy:
The biggest challenge that individuals face when implementing a charitable bunching strategy is having the resources to fund multiple years’ worth of charitable giving in a single year.
Typically the best option for funding a charitable bunching strategy is through gifting long-term appreciated stock held in a taxable brokerage account. Gifting long-term appreciated stock allows the donor to avoid paying capital gains taxes on the appreciated positions.
Other options for funding a charitable bunching strategy include giving appreciated real estate or privately held business interests. For individuals without appreciated assets, cash becomes the default option.
If an individual does not have enough appreciated investment assets or cash to fund multiple years’ worth of charitable giving in a single year, the individual will need to wait until future years to implement a charitable bunching strategy.
Individuals who plan to implement a charitable bunching strategy in future years can begin setting aside funds annually so they have the cash they need to fund a charitable bunching strategy in the future.
Key Takeaway:
The primary challenge with a charitable bunching strategy is having the capacity to make multiple years’ worth of charitable contributions in a single year.
Conclusion
Families who prioritize creating a legacy through charitable giving can minimize their tax burden through strategically bunching their charitable deductions. Implementing this strategy can be done simply and effectively without placing any inconvenience on the charities supported by using a donor advised fund.
If you are interested in working with a Family CFO and learning how to maximize the tax benefits of your charitable giving, we would love to connect to see if what we do is right for you.
