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How do donations affect taxes?
From the Tony Robbins Tax Guide
The secret to living is giving. Donating to charity makes a difference in the world and is part of living a balanced life of gratitude. Many people don’t even stop to consider this important question: How do charitable deductions affect taxes? But when they do, there is good news. In general, donating to charity will lower your adjusted gross income (AGI) – and therefore the amount of tax you pay.
It’s a different story for individual donations. When you move cash from one party to another, whether it’s in the form of a monetary gift to a family member or paying for someone’s college education, you are opening yourself up to possible additional taxes you will need to pay.
Whether you’re wondering how donations affect taxes or how you can leave a legacy for your family, these tax tips will maximize your benefits and help you create the financial future you dream of.
How do donations affect taxes?
Generally, charitable donations are deductible on your annual tax return. This means you can subtract them from your income before calculating how much tax you owe – and therefore pay fewer taxes. However, there is a limit to how much you can deduct: it’s usually 60% of your adjusted gross income (AGI), but can be 20%, 30% or 50% depending on the charity and contribution type. There is also a process to “carry over” donations that exceed the maximum amount to the next year’s return.
So how does donating to charity affect your taxes? The answer is that it’s complicated – but almost always positive. Follow these top tips to maximize your charitable donations’ effect on your taxes.
Follow the rules
Make sure you’re donating to a tax-exempt organization that is registered with 501(c)(3) or 170(c) status. You can check an organization’s status with the IRS Tax Exempt Organization Search. The charity will also be able to help you figure out how much you can deduct – for example, veterans organizations and some private foundations have lower limits.
Always keep documentation, no matter the amount of the donation. You’ll need to itemize your deductions when you file your taxes, rather than taking the overall standard deduction. If you’ve been wondering, “How do donations affect taxes?” this is one of the major ways. It can take more time to itemize, but it is worth it for large donations.
Create a donor-advised fund
Donor-advised funds are established at public charities that act as charitable investment accounts. You contribute cash, mutual funds or stocks and invest them. You control the dispersal of the cash to the charities of your choice, while also earning tax-free growth on your investment.
Donor-advised funds allow high net-worth households to take advantage of charitable gift “bunching” in order to claim higher tax deductions. Bunching typically benefits married donors whose itemized deductions are below the new, higher standard deduction introduced in 2017’s Tax Cuts and Jobs Act ($24,400 for married couples filing jointly). In considering how charitable deductions affect taxes, these couples can turn to this strategy, which involves making a large donation in one year, rather than smaller donations over several years. The donation is made to the donor-advised fund, which then disperses the money to qualified charities. The taxpayer can then claim the deduction for that year.
Donate stock, not cash
It pays to donate to charity from your investment income, rather than cash. There is a tax strategy which allows you to give the maximum amount to the charity of your choice, without being taxed.
There are two main benefits to this technique: if you donate income from an appreciated investment that you have owned for at least one year, you no longer need to pay capital gains tax. Secondly, you can still claim a charitable donation deduction for the entire market value of that appreciated stock.
In the end, the charity ends up with a larger donation than they would have had you sold the stock and donated the cash instead. Plus, you get the full tax write-off and avoid taxation, so it’s a win-win situation.
How do contributions to individuals affect taxes?
Let’s say, hypothetically, you win the lottery. You’ve hit it big and are now a multi-millionaire. Being the generous person you are, you immediately think to share a piece of the pie with your family. Giving away money should be easy, right? But it’s not that simple. Contributions to individuals are never tax deductible – and in fact, may actually incur more taxes.
“Monetary gifts” are governed by a strict set of rules, which tell you how much you are allowed to give to your friends and loved ones — and within what timeframe. The rules also dictate how much of a “gift tax” you will have to pay on it.
As of 2020, gifts in the amount of $15,000 or less are transferable without incurring any gift tax. In other words, you can give up to $15,000 to any one or more persons in any given year and not be taxed for it. Anything exceeding that amount needs to be reported on Form 709. How do these donations affect taxes? You’ll have to pay a gift tax on them – but there are ways you can reduce the tax you pay.
But don’t fret; there is another option, in the form of a credit, called the lifetime or unified credit. As of 2020, this credit allows you to give up to $11.58 million per person, which means you technically don’t need to pay any tax on the gifts you give until you reach that cap. However, you still have to report that amount on Form 709 so that the gift amount can be deducted from your unified credit balance. If you exceed the unified credit amount in your lifetime, the result will be very heavy taxation on any future gifts. For those who have a lot to give, that is a major consideration.
Irrevocable life insurance trust
For those who give in large amounts exceeding the unified credit of $11.58 million, they can open an irrevocable life insurance trust, or ILIT. This policy is technically owned by a trustee, so, in effect, you can transfer your annual gifts to the trust and eliminate your need to pay the gift tax.
The example shown below illustrates what happens if John donates $20,000 a year and $6.43 million in his lifetime.
The 529 college savings plan
Paying for a loved one’s college education is one of the greatest gifts you can give. But like all individual gifts, how donations affect taxes depends on the way it is set up. For many, the popular 529 college savings plan is the solution to this tax problem.
With the 529 college savings plan, you can put money away without having to pay federal tax and in some cases, state tax — as long as it’s used as tuition for a qualified educational institution. If not, you will be subject to income tax as well as a 10% tax penalty.
There are other benefits to this savings plan as well. In the tax code, there is a provision that allows consumers to take five years of gift tax exclusions within one year — up to a certain amount — by contributing to a college savings plan. Some states let you deduct a portion of your contribution to this savings plan from your taxes, up to $10,000 per year, depending on the state.
There’s no reason to let concerns about how charitable deductions affect taxes keep you from seeking meaning and fulfillment through donations. Done right, charitable giving is an essential part of your long-term estate planning. More importantly, it can be one of life’s greatest pleasures.