This is professor Russell James at Texas Tech University. Welcome to “A Donor’s guide to the 2018 Tax Law”
The new tax law has both positives and negatives for charitable donors.
For most people, the special tax benefits from giving appreciated assets actually went way up.
For some people, the tax benefits from giving cash went up, for some they didn’t change, and for some, they went down. But, even for those whose tax benefits went down, there may be a way around it with proper planning.
So let’s dive into these changes.
First, let’s look at giving assets.
Giving assets has always been smarter than giving cash. Why? Because giving appreciated assets creates two tax benefits instead of one. You get the same income tax deduction as a gift of cash, but you also avoid capital gains taxes.
Let’s look at an example.
Mary has $10,000 in cash and $10,000 of IBM stock that she paid $1,000 for a few years ago. She wants to make a $10,000 gift to her favorite charity. Should she give the cash or the stock?
If she gives the cash she gets a $10,000 charitable tax deduction, and she keeps the $10,000 of IBM stock that she bought for $1,000. When she sells the stock she must pay capital gains taxes on the $9,000 of growth, in other words, the difference between the $1,000 she paid and the $10,000 it is now worth.
If she gives the stock, she gets the same $10,000 charitable tax deduction. But, by using the $10,000 of cash she didn’t donate to then immediately purchase $10,000 in new shares of IBM stock, she eliminates all capital gains taxes from the growth of the stock. When she sells the stock, she now pays NO capital gains taxes on the $9,000 of growth, because there is no difference between the $10,000 she just paid and the $10,000 it is now worth.
This idea doesn’t change under the new tax law. What does change is that for most people it is now more valuable to avoid those capital gains taxes. If you are like 80% of Americans and live in a state that charges capital gains taxes, your effective rates probably went up. Although the rates themselves didn’t change, you now pay more because you probably can no longer deduct the money you pay for state capital gains taxes. (You probably can’t use the deduction because you are already over the $10,000 cap for this deduction or, with the new standard deduction, you aren’t itemizing at all.)
Let’s look at an example.
Suppose Mary lives in California and pays top tax rates. In 2017, she would have paid a net capital gains tax of 31.83%. In 2018, she would pay a net capital gains tax of 37.10%. This increase comes because in 2017 she would have been able to use a deduction for paying the state capital gains taxes, but not in 2018.
Donating stocks in 2017 saves her $2865 in capital gains taxes ($9,000 of gain x 31.83% combined rate). Doing the same thing in 2018 saves her $3339 in capital gains taxes ($9,000 of gain X 37.1% combined rate).
So, the tax benefits from giving appreciated assets like stock just went up. This is true even if Mary wanted to earn income from the gift using a charitable gift annuity or charitable remainder trust.
What if Mary wants to give to a local charity that doesn’t know how to take gifts of assets? No problem. She simply opens a donor-advised fund account, gives the assets to the fund, then directs the fund to write a check to her favorite charity.
But, what about people who only want to give cash. What is different in the 2018 tax law?
For some people, the tax benefits have gone up. In 2017, net state tax rates were lower, because of the offsetting federal deduction. In 2018, that deduction was capped. These higher state taxes make charitable deductions that reduce state taxes even more valuable.
Let’s return to our example. If Mary donated $10,000 in 2017, she received a $10,000 deduction for her state taxes. This reduced her state taxes by $1,330 (13.3%), but increased her federal taxes by $526.68 (13.3% x 39.6%). The increase in federal taxes came because she lost the federal deduction from paying the extra $1,330 in state taxes. If Mary donated $10,000 in 2018, the gift still reduces her state taxes by $1,330. But, this reduction doesn’t change her federal taxes because of the cap on deductions for state taxes. Thus, the net value of the state tax deduction has grown from 8.03% (13.3% state – 5.27% federal) to 13.3%. This increase in the value of the charitable gift for state taxes more than offsets the reduction in the top federal tax rate, meaning that overall the charitable deduction is more valuable for Mary in 2018 than it was in 2017.
But, what if Mary lives in one of the eight states that don’t charge any state income taxes? The charitable deduction might still be more valuable for her in 2018 than in 2017. If Mary was a single person making between $200,000 and $416,700, then her federal tax rates actually increased in 2018. Thus, if she can still use the charitable tax deduction, it was worth 33 cents on the dollar in 2017, but is worth 35 cents on the dollar in 2018.
Even if Mary’s federal tax rates didn’t go up, the charitable deduction might still be more valuable to her in 2018. In 2017, charitable deductions were reduced by 3% of income over $261,500 for individuals (called the Pease limitation). This reduction disappeared in 2018, making charitable deductions even more valuable.
Finally, in 2018, Mary can deduct up to 60% of her income with charitable donations of cash, but in 2017, she could deduct up to only 50%.
Of course, for some people, the tax benefits of donating went down. Because the standard deductions are higher in 2018, some people itemized their deductions in 2017, but won’t in 2018. That means they could use a charitable tax deduction in 2017, but can’t use it in 2018.
Even for these people, there may be a way around.
If a donor is age 70 ½ or older, the best way to donate is to give money directly from an IRA (for more information on IRA’s and charitable rollovers, visit here). Even though this gift counts as part of any required minimum distribution, it doesn’t count as income to the donor. For many tax reasons, it is better to have lower income with no deduction than to have higher income with a deduction. So, for those in this age group, shifting from itemizing in 2017 to not itemizing in 2018 makes no difference, at least for charitable gifts of $100,000 or less coming from an IRA.
But, what about donors who did itemize in 2017, but aren’t itemizing in 2018, and who aren’t older than 70 ½? Do they have to lose the charitable tax deduction? Not necessarily. If charitable gifts and other deductions are less than the standard deduction, it is better to take the standard deduction. But, if a donor has financial flexibility, they can pick a target year and pre-fund several years’ worth of their charitable giving. In the target year, the donor transfers money into a donor-advised fund to cover several years’ worth of future donations, taking the entire tax deduction up front. The donor itemizes deductions in the target year, using this big charitable deduction all at once. In the off years, the donor just takes the standard deduction. In these off years, gifts to charities come from the donor-advised fund, using money that was already deducted back in the target year. This not only creates a better tax result, but can also result in even bigger gifts to charities. While the money is in the donor-advised fund, it can still be invested and it grows tax-free.
Overall, the new tax law has both positives and negatives for charitable donors. But, the positives can be even greater for those who plan ahead. So remember these rules:
- Donate appreciated assets
- If you are age 70 ½ or older, donate from your IRA
- If you won’t always itemize, then make planned future gifts to a donor-advised fund in an itemizing target year and pay these out to charities during non-itemizing off years.
This has been professor Russell James at Texas Tech University. Thanks for watching, “A donor’s guide to the 2018 tax law”
Published with permission of Dr. Russell James, Texas Tech University
This article is a transcript of video posted at https://youtu.be/D2_RRELkDxo