Being Smart about Donations can Save a Lot in Taxes

Did you know that the federal government will pay you to give money to your favorite charity?

web-tax-axstj-taximg_0779-stj3-1013-6299.jpgThe “payment” does not come directly, of course – but in the form of a break on your income taxes.

If you’re careful, this payment can reduce the cost of your charitable giving by one-third to one half – and in certain limited occasions even more.

If you remember nothing else about this particular column, remember the following numbers. Though they are only rough approximations, they are close enough to make the point:

$1000 = $750 = $500

But before I explain why — a warning.

Be sure to check with your tax advisor before counting on the applicability of strategies discussed below. In fact, for this column I consulted a certified public accountant, who noted: “As with any tax savings strategy, a little knowledge can be a dangerous thing. These examples are hypothetical and ideal scenarios designed to educate, not advise on specific situations.”

Now, with remembering to always check with your tax advisor before acting on anything you read here – on to tax law and math.

$1000 = $750

Most people know they can deduct donations made to charitable causes. Fewer, however, have really run the numbers to realize what this is worth.

In 2009, a couple whose taxable income was between $67,900 and $137,050 paid a marginal federal tax of 25% on every $1 earned over $67,900.

By deducting charitable contributions totaling $1000, this couple could potentially save $250 in taxes (25% of $1000), which means that the $1000 donations to charity only really “cost” them $750.

The higher your income, the higher the value of the charitable donation deduction.

For instance, a single person with over $373,000 in taxable income in 2009 may have found that a $1000 contribution to a charity only cost $650 thanks to the ability to deduct the donation against a 35% marginal tax rate.

The value these potential deductions may be limited by several “wrinkles” in federal tax law, which is why it is important to consult a tax advisor. More often than not, though, these deductions substantially reduce the effective cost of charitable giving to donors.

$1000 = $500

The next way to reduce the effective cost of donations to a charity is to give away highly appreciated investments instead of cash. Combined with the deduction, in certain situations, giving away appreciated securities can reduce the cost of giving $1000 to roughly half.

To understand why, you need to know that long term increases in the value of your investment assets (stocks, bonds, real estate, business) are generally (but not always) taxed at 15%.

So, for instance, last year if you sold $1000 worth of General Electric for which you paid the equivalent of less than $10 in 1970, you would have owed nearly $150 in federal “capital gains” taxes (15% of the $990 growth in value).

This means that to you, $1000 of your GE stock was really worth only a little more than $850 once you had paid the taxes ($1000 minus nearly $150).

However, to the charity that receives your GE stock, it would have been worth $1000, because charities don’t pay capital gains taxes when they sell the stock.

And, since the charity gets the full value of the $1000, you get to deduct the full $1000 value of the gift. As we discussed before, this can save people in the 25% – 35% federal tax rate from $250 to $350 in taxes on a $1000 gift.

So, by giving away $1000 worth of appreciated stock that was worth only $850 after taxes, that person may be able to harvest an additional $250 to $350 in tax savings. Subtract that amount from $850 (that the donation was worth to the donor in the first place), and the net cost of the $1000 gift comes in between $500 and $600. If, as most anticipate, capital gains rates are allowed to rise to 20%, then the total after-tax cost of a charitable gift will be even less.

One easy way to take advantage of these rules is to establish a “gift fund” account somewhere like Fidelity Charitable Gift Fund, or to contribute to a local community foundation, which typically have people who can help potential donors evaluate how to give in the most tax-efficient manner possible.

However, thanks to the alternative minimum tax and other complexities in our tax code, it is critically important for you to check with your tax advisor before applying any information in this article to your specific situation. Odds are high, though, that if you give much to charity and invest in stocks, the cost of charitable giving can be reduced to significantly lower than the cost of the contribution.