The IRS provides tax breaks to encourage and incentivize charitable donations. These tax breaks help us maximize our charitable giving and reduce the personal burden of having to pay taxes on income that won’t flow to our own wallets but instead go to a greater good. Tax breaks will vary depending on how much we donate, what types of assets we donate, and which types of accounts we use to make those donations.
In this post, we’ll specifically delve into the three primary types of tax breaks associated with charitable donations.
For a more comprehensive understanding of how to apply these tax-efficiencies to your donation strategy, make sure to download Yield & Spread’s Giving Guide!
Here are the three main types of tax breaks you can get when it comes to donating:
A tax deduction: When you donate assets, such as cash or securities, you can claim an immediate tax deduction in the year of the contribution. This deduction reduces your taxable income, potentially leading to a lower overall tax liability for that year. I use the word potentially as you need to donate a certain amount of money in any given tax year to be able claim this deduction for your charitable giving.
Capital gains tax avoidance: Capital gains are incurred when you sell an asset and make a profit. There are many ways to avoid this tax on profits when it comes to donating.
Dividend & Interest tax avoidance: When you invest, you earn dividends from stocks and interest from bonds. Interest gets taxed similarly to income, while qualified dividends get taxed similarly to capital gains.
We discuss all this an more in our Learn to Invest course, but for now let’s dive into each of the three types!
Deductions: Lowering your taxable income
Whether or not your charitable donation is tax deductible is totally dependent on whether or not you have met the standard deduction in any given tax year.
A little refresher here: The standard deduction is a fixed reduction in your taxable income, while itemizing deductions involves listing specific eligible expenses, like mortgage interest or charitable giving, to reduce your taxable income. You choose either to take the standard deduction or to itemize based on which gives you a larger tax benefit. (You can view a complete list of what is deductible on the IRS Schedule A Form 1040). Generally speaking, you can only itemize charitable contributions if you are making donations to qualified 501(c)(3) nonprofit organizations, although there are some exceptions.
The vast majority of Americans claim the standard deduction because it is so high (in 2023, it is $13,850 for single filers and $27,700 for married filing jointly). This means you’d have to donate enough money in any given tax year, to bring you above that standard deduction amount to make it worthwhile to itemize your deductions. Translation: you have to be donating meaningful sums of money to see a tax deduction.
Charities will often market to you and say “Make your tax-deductible donation today!”. This can be somewhat misleading, in that your donation is not tax deductible unless your donations push you above and beyond the standard deduction.
It’s important to note that you can lower your taxable income by donating cash and/or securities (stocks, bonds, funds, and ETFs). Depending on the type of asset, you will face limitations on just how much of your donations are tax deductible, but this is typically for donors giving away large sums of money. If you are a big time donor giving away more than 30% of your Adjusted Gross Income, you’ll definitely want to check out this blog post on deduction limitations.
If you are donating on a regular basis but not quite at the level in which it would be worth itemizing, there may still be a possibility to meet or exceed the standard deduction by bundling (or bunching) your donations from multiple years into one. Read more on this strategy here.
Capital Gains Tax Avoidance
Capital gains tax applies to donating securities, or stocks, bonds, funds, and ETFs. It, of course, does not apply to cash donations as we don’t make gains on our cash!
When you sell an appreciated share of a stock, bond, or fund, you can face capital gains tax on the profit. In other words if you buy a share of stock for $20, and then sell it at $50, you’ll have a profit of $30, and the IRS will tax you on that. How long you’ve held onto that asset will impact your tax-rate.
As we explain at length in the Learn to Invest course, a long-term gain is for an asset you’ve held onto for more than a year. A short-term gain is for an asset that you’ve held onto less than a year. As you can see below, long-term gains are taxed more favorably than short-term gains. More often than not, you’ll be looking at facing a 15% long-term capital gains tax rate for any profits.
The great news is that when you donate appreciated assets directly to charity, you can avoid this capital gains tax. This is true whether you donate those assets directly from your Regular Brokerage account or a Donor-Advised Fund, or even your IRA!
The important thing to remember for this capital gains tax avoidance to work is that you DO NOT liquidate your assets (or sell your funds to turn them into cash). If you do liquidate your assets, it causes an unnecessary capital gains tax event and you’ll have to pay for that even if you meant to simply donate that amount to charity.
Dividend/Interest Avoidance
Dividend and interest taxes are the most simple to explain of the three tax breaks. When you invest, you will likely earn either dividends or interest from your investments over time. When you earn dividends/interest in your regular brokerage account, you will likely have to pay taxes on this regardless of whether or not you plan to donate these assets.
That’s one of the reasons why people like tax-advantaged accounts, because they typically help you avoid dividend/interest tax. For example, a donor-advised fund (DAF) will certainly help you avoid this type of tax (as will the retirement funds you likely contribute to already, like an IRA or a 401(k)
Key Takeaways
In a perfect, tax-efficient world, you would able to do all of the following:
Lower your taxable income through charitable tax deductions
Avoid capital gains tax on appreciated assets
Avoid dividend/interest tax on your assets while they remain invested
But not all three are always possible to do at once depending on the type of asset you want to donate (cash or stocks) and the account you donate from. Nor does it always make sense to wholly prioritize tax efficiencies if there are other things you value, like having full control over what you invest in or where you make donations.
To help you navigate these choices, make sure to download Yield & Spread’s Giving Guide today!
Disclaimer: The information contained in the Yield & Spread website, course materials and all other related content is provided for informational and educational purposes only. It is not intended to substitute for obtaining accounting, tax, or financial advice, and may not be suitable for every individual. Yield & Spread is not a registered investment, legal or tax advisor or a broker/dealer.