Let’s return to one of my favorite topics: taxes. And in this post, I’ll talk about one aspect of taxes that most of us have heard of, but may not know too much about: charitable contributions.
We’ve all heard the common refrain that charitable contributions are “tax-deductible.” And that refrain is indeed correct, there is a tax deductible nature to charitable contributions. Let’s talk about what exactly that means, what qualifies, and what else you might need to know.
“Tax-Deductible”
Starting with the basics, what does it mean when a charitable deduction is “tax-deductible?” Well, it doesn’t mean that a charitable deduction is a dollar for dollar offset of the taxes you owe; rather, a charitable contribution can be deducted from the income that is subject to taxes.
An example? Sure.
Assume you have $100,000 of income and that your effective tax rate is 30%. Without any deductions, this would mean you’d pay $30,000 in taxes on that $100,000 of income.
Now let’s assume you made a charitable donation of $1,000 during the year. You’d be able to deduct that $1,000 from the income subject to tax, meaning that you deduct the $1,000 from your $100,000 of wage income. Subtracting $1,000, you reach an adjusted income of $99,000, and that’s the amount on which the 30% tax rate is applied. This means you pay $29,700 in taxes.
So you see your $1,000 charitable contribution saved you $300 in taxes. Incidentally, you can see that the amount you save in taxes depends on your tax rate. If your tax rate were lower, say 20%, you’d save $200 in taxes, whereas if your tax rate were higher, say 40%, you’d have saved $400 on your taxes. This means that those with higher incomes, who are generally subject to higher tax rates, reap a higher tax deduction from a charitable contribution than someone with a lower income subject to a lower tax rate. It’s not exactly aligned with the goal of a progressive tax system (i.e., higher earners pay more taxes), but that’s the current state of affairs.
That’s basically how a charitable deduction works, but, as with anything related to taxes, it’s not quite so simple. So let’s talk about when you’re able to take that charitable deduction.
Qualifying Types of Charitable Contributions
You have to keep in mind that not every dollar you give for charitable causes qualifies, though a good amount of them do. Primarily, you have to give to the right type of charity. The tax code defines exactly what qualifies for a charitable deduction, and provides the following definition of a charitable organization:
“organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.”
There are others too, but that’s the basic definition of a charitable organization. If you like reading the tax code, go to 26 U.S.C. 170, available at:
https://www.law.cornell.edu/uscode/text/26/170.
The IRS website also describes charitable organizations for you:
If you go to your local Salvation Army or similar organization, one thing you’ll see on their website or materials is that they’re a “501(c)(3)” organization, which is not just a cool nickname. That combo of numbers and sections refers to section 501(c)(3) of the tax code, which provides the requirements for an organization to be exempt from federal taxes. This means that a qualified 501(c)(3) organization does not pay corporate or other federal taxes. But it also means that a donation you give to them is eligible to be tax deductible for you.
Nevertheless – and this can be important – it doesn’t mean that an organization must be a 501(c)(3) organization for your donation to qualify for a tax deduction – the applicability of the tax deduction rules are broader. It does mean, however, that if you’re giving to a 501(c)(3) organization, your contribution is more than likely deductible.
Another thing to know is that typically if you receive something in return for your contribution, it won’t be (entirely) deductible. If you give money to a 501(c)(3) organization but that money gets you tickets to an event, or a raffle entry, or something like that, the contribution won’t always be deductible. There’s no bright line with what counts here, so if you do receive something in return for your contribution, make sure you research whether all or part may not qualify for a charitable deduction. This is where you probably need to get your accountant (or lawyer) involved to figure it out for you.
Itemized vs. Standard Deduction
Ok, so let’s say you make a contribution to an organization that qualifies for a tax deduction – does that mean you still get to take it off your taxable income? Not necessarily.
Most people are probably familiar with the terms “standard” and “itemized” deductions, and if you haven’t heard of them, well, now you have. I won’t start to explain why there are standard and itemized deductions for different taxpayers. That’s a topic for another day. But the distinction is important to determining whether you can take a charitable deduction from your taxable income.
Both standard and itemized deductions reduce the amount of tax you owe by lowering the amount of your income that is subject to taxes – kind of like the example discussed earlier. In 2020, the standard deduction for a single filer was $12,400. This means that if you had $100,000 in income, and you take the standard deduction, you reduce that $100,000 by $12,400 to determine how much tax you owe. Basically, if you take the standard deduction, you would pay tax as if your income were $87,600.
Itemized deductions, in contrast, are specific items that can be deducted from your taxes instead of the standard deduction. Itemized deductions include such things as certain medical expenses, state and local property taxes, casualty losses, mortgage interest, and, as you might expect from the topic of this post, charitable contributions. Each of those, of course, has certain limitations on how much you can deduct or when they qualify.
Here’s an important point: you can only take either the standard deduction or you can itemize deductions. You’d generally only itemize deductions if the amount that qualifies for itemization is greater than what the standard deduction would be. For that single taxpayer above, if you didn’t have more than $12,400 worth of itemizable deductions in 2020, then taking the standard deduction would save more on taxes than itemizing.
It’s here I’ll note here that the example above is a bit of an oversimplification of how taxable income is calculated. As you might imagine, there’s quite a bit more that goes into it than how I’ve stated it above. A brief overview will take this discussion to the next level.
When calculating your income that is subject to taxes, the first thing that needs to be determined is your gross income. Gross income is the total of all money you made, including wages, capital gains, dividends, etc.
Then, there are two types of deductions, “above the line” and “below the line.” An above the line deduction is an adjustment to your income that you’re allowed to take to reduce the amount of income you’re considered to have received. This includes things like contributions to a 401(k) or IRA, health insurance for self-employed taxpayers, student loan interest (in some cases), certain tuition costs, health savings account contributions, and others like this.
Once you take all the above the line deductions, you get a number called your “Adjusted Gross Income,” or AGI for short. In the example above, I’m using the $100,000 as the AGI. Then, you move on to the below the line deductions, which are the standard or itemized deductions. You subtract the amount of the standard deduction, or itemized deductions, depending on which you’re taking, from your AGI and arrive at the amount of your taxable income.
There’s still more to it than this, but this should be sufficient for our purposes. So why is this important?
Well, as you can see from the above, because charitable contributions are itemized deductions, you would only take them if you itemize. This means that if you take the standard deduction, you can’t deduct your charitable contributions from your income. Boom.
It’s worth noting that there are some limited situations where even those who don’t itemize can reap some tax benefit from a charitable contribution. Because what’s a tax rule without an exception?
For example, in 2021, taxpayers taking the standard deduction could deduct up to $300 (single)/$600 (married filing jointly) for certain cash contributions to charitable organizations. This limited situation essentially makes charitable contributions an above the line deduction for taxpayers who take the standard deduction and would not normally qualify for a tax deduction for donations to charity. But, for the most part, absent one of these limited and narrow situations, you have to itemize to take advantage of a tax benefit from charitable contributions.
Substantiation
Another point I’ll make is the importance of what the IRS calls substantiation. Substantiation means that you have to be able to prove that you made the charitable contributions that you’re claiming. Typically a canceled check will do it for money donations, but you’d be wise to look into this before you donate. This is particularly so when you donate property, including things like old clothes.
First and foremost, make sure you get a receipt. For property over a certain value, the IRS requires even more detailed verification, including, for example, that property donations over $5,000 receive an appraisal. Before you make a donation (particularly a large one), look up what you need to get so that you have the right paperwork. You’d hate to be caught without it if you get audited.
Limitations on Amount of Charitable Deductions
And finally, one more aspect of note for the curious among us. Even if you itemize, there are limits to how much you can deduct in charitable contributions from your adjusted gross income. For the most part, you can only deduct up to 50% of your adjusted gross income using charitable deductions. Some deductions to private foundations, veterans organizations, fraternal societies, and cemetery organizations are limited to 30% of AGI.
Not to fear too much, however, as you can generally carry over excess contributions (those that exceed the applicable % cap on AGI) for up to 5 years, much in the way you carry over capital losses for a certain period until you use them up. So if you have $100,000 of AGI in Year 1 and $60,000 in charitable contributions, you can deduct up to $50,000 in Year 1, then carry over $10,000 and deduct that from your AGI in Year 2.
The main point is that you generally can’t offset your entire income using charitable deductions unless there is a specific exception to the AGI limit. (Which does happen from time to time, such as the Coronavirus-related CARES Act that allowed deductions of up to 100% of AGI for certain types of contributions for a limited time).
For the FIRE Investor
So, what does this mean for a FIRE investor? Well, generally it means that if you itemize deductions, you can reduce your tax bill with certain charitable contributions. Of course, the amount of your tax reduction will be less than the amount you donate; but don’t let that dissuade you from donating to charities. The same goes for those who take the standard deduction. Although you may not end up with tax savings, you don’t have to let that drive your decision of whether to help a worthwhile cause.
As you can see by the discussion above, the system of who benefits (tax-wise) from charitable deductions is not very progressive, skewing toward high earners. Primarily, those with higher tax rates save more on taxes from the same deduction than someone with a lower tax rate. And that’s even among those who qualify because they itemize. Most itemizers are those who own their own homes (and have mortgage interest) and/or live in an expensive place with high state and local taxes.
Even if you don’t get to take an itemized deduction, or you take a fairly small deduction, it’s not a bad thing to donate to charity. As I’ve said before, while FIRE is about maximizing your savings, it’s not about living a life where you’re so frugal that you miss the bigger picture. Charitable deductions fall into that category. They may not boost your savings, but it’s important not to lose focus on everything but that. If you’ve saved up for long enough, you’re likely fortunate enough to have the money to be able to donate to charity. Don’t become so focused on saving and maximizing value that you forget to do other things that matter.
Finally, one more word of caution. Charitable deductions, like most tax topics, are anything but simple. I’ve tried to explain some of the basic concepts above, but, like everything I write, this is not tax or legal advice, and make sure you get proper advice if you don’t know what you’re doing. Exceptions to exceptions are the rule and not the exception, and you don’t want to take too many chances when it comes to your taxes.
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