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Free Lunch

Adam M. Grossman  |  April 3, 2018

PERHAPS YOU’VE HEARD the expression, “there’s no free lunch.” The idea is, you usually don’t receive something for nothing. Whether it’s with money or with time and labor, you almost always “pay” one way or another.

It’s an interesting concept—but whoever coined the phrase clearly never looked at the U.S. tax code, which is full of free lunches. Today, we’ll discuss one example, which may be of interest to the charitably inclined.

One of the most talked about changes in the new tax law is a provision that alters how deductions are treated. In the past, you were able to take a federal tax deduction for the entire amount you paid in state and local taxes (often abbreviated as SALT), including real estate taxes. But under the new rules, taxpayers can deduct just $10,000 of SALT taxes.

At the same time, the standard deduction was nearly doubled to $24,000 for a couple filing jointly. Because of these changes, many taxpayers who previously were able to itemize their deductions—and thereby receive a benefit for each and every charitable donation—no longer can. Instead, they may be limited to the standard deduction.

How can you use these changes to your advantage? Suppose you and your spouse earn a combined $250,000, and suppose you like to give away 5% of your income, or $12,500, each year. To make these contributions, you could take the traditional approach and simply write checks directly to your favorite charities. But there’s a better way—a much better way—that will result in a fairly substantial free lunch.

Here’s how I would approach it: Instead of giving $12,500 every year, give away twice as much, or $25,000, every other year. Over time, the total will be the same, but in some years you’ll double up your donations and in some years you won’t donate anything. Of course, the charities that depend on your check every year may not want you to switch to an every-other-year schedule, but I have a solution for that. It’s called a donor-advised fund or DAF. They’re available from major financial firms like Fidelity Investments, Charles Schwab and Vanguard Group. A DAF is a sort of hybrid between a charity and a checking account.

The charity part issues you a receipt right away when you make a donation. But the checking account portion holds onto your funds, in a separate account that you control. Your money doesn’t go anywhere until you ask the DAF to send a check to one of your charities, which you can do at any time. In combination, these two aspects allow you to schedule your donations for tax purposes every other year, while still allowing you to send your favorite charities a check every year.

Let’s look at the tax impact, comparing the traditional approach to the approach I’m describing:

Scenario No. 1: Traditional Approach

In this scenario, you make $12,500 of charitable donations every year. You start with your $250,000 income and then subtract your deductions. The maximum deduction for state and local taxes is $10,000 and your charitable donations are $12,500. That adds up to $22,500. Because this is less than the $24,00 standard deduction for a couple filing jointly, you opt for the larger standard deduction. That means your taxable income is $226,000 and, based on 2018’s tax tables, your tax bill is $42,819.

Scenario No. 2: Donor-Advised Fund

In this alternate scenario, you make a $25,000 donation every other year. Again, you start with your income of $250,000 and subtract your deductions. Your state and local taxes are still capped at $10,000, but now your charitable contributions are $25,000, bringing your total deductions to $35,000. This is far above the standard deduction, so you can now deduct the entire $35,000. This lowers your taxable income to $215,000 and your tax bill to $40,179.

Result: In scenario No. 1, your tax bill was $42,819, but in scenario No. 2 it was quite a bit lower, at $40,179, providing a savings of $2,640. Of course, you’ll only realize this savings every other year, when you make your charitable contributions. But here’s an important point: In the years when you don’t make any donation, you still get to take the standard deduction, so your tax bill is no higher than if you were making a $12,500 contribution. That’s why it’s so important to double-up your donations in the years that you give, so you receive the full tax benefit.

Is this truly a free lunch? I believe so. Yes, it requires a little bit of administrative work, you need to be charitably inclined and donor-advised funds do charge some minimal fees. And, of course, you’ll want to verify with your tax advisor that this strategy will work with your overall tax picture. For many people, though, it’s hard to see why they wouldn’t want to do this.

One more thing: Donor-advised funds also make it easy for you to donate appreciated stock. They sell the stock for you, allowing you to donate the cash proceeds to charities. In addition to convenience, this provides an additional tax benefit, because you sidestep the capital gains taxes that would have been due if you had sold the stock yourself. Got a stock portfolio with unrealized gains? I would definitely explore this strategy.

Adam M. Grossman’s previous blogs include Face Plant, Eye on the Ball and Pouring Cold Water. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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