The Tax Benefits of Making Charitable Gifts While Alive
The tax benefits of charitable giving for most taxpayers have been reduced in recent years due to changes in tax law. In terms of income tax, many fewer taxpayers itemize due to the increase in the standard deduction to $12,400 for individuals and $24,800 for married couples (in 2020). As a result, only about 30% of taxpayers itemize their deductions, meaning that the other 70% cannot benefit from the income tax charitable deduction.
Further, only the very largest estates pay federal estate taxes with the threshold at $11.58 million per individual and $23.16 for married couples (in 2020), so almost no one benefits from the federal estate tax charitable deduction. Some states have lower thresholds, meaning more estates in those states can benefit from the charitable deduction.
If you do itemize your deductions, than you can deduct your charitable gifts from your taxable income up to a limit of 50% of your adjusted growth income (with a 30% limitation for some specific types of charities). So, for instance, if you are in the 33% federal tax bracket, a third of whatever you give away will be made up by lower taxes. If you give away $1,000, you will reduce your federal income tax by $330, lowering the after-tax cost of the gift to $770. The tax savings will be even greater if you live in a state with its own income tax, since you will also receive a state income tax deduction. Of course, as with all tax deductions, the higher your income, the higher your tax bracket, and the bigger your charitable deduction. In addition, to take advantage of the charitable deduction at all, you have to itemize your deductions.
If you do have a federally taxable estate, the benefit of the deduction may be even greater, since you will get two tax benefits from the gift — the income tax deduction, plus lower estate taxes, since your estate will be that much smaller. The latter can be significant since the federal estate tax rate starts 40%. For a simplified example, let’s assume your estate totals $20 million and you want to give $1 million to a charity (perhaps your alma mater will name a professorship in your memory). Assuming that you are in the 35% income tax bracket, if you give this money during life, you will save $350,000, bringing the after tax cost of the gift down to $650,000. (You’ll probably have to give the money over several years in order to take full advantage of the deduction.) At your death, your estate will be $650,000 smaller, reducing your estate tax by $260,000, resulting in $610,000 of combined income and estate tax savings. If you simply made the gift at death, your estate would save $400,000 in estate taxes, a loss of more than $200,000 in potential tax savings.
Of course, this calculation is irrelevant to most people, who don’t have federally taxable estates. While the deduction will also be available if you live in a state with its own estate tax which kicks in at a lower threshold, the state estate tax rate is likely to substantially lower than the federal tax rate, reducing the benefit of this deduction.
In short, tax-driven charitable giving through estate planning is the domain of the wealthy who have federally taxable estates. They should consult their tax advisors in making charitable giving plans. For everyone else who itemizes, there’s a tax incentive to make donations during life rather than at death. But that needs to be balanced with the need to maintain financial security.