- The storm and stress of 2020 has made charities more vital to the public than ever.
- Now is an ideal time for charity-minded investors to think about which causes and organizations are closest to their hearts and how to donate in a tax-efficient way.
- Let's look at the comparable after-tax benefits of three basic methods of charitable giving.
Rey Santodomingo, Director of Investment Strategy - Tax Managed Equities, Parametric
The storm and stress of 2020 has made charities more vital to the public than ever. From health care to income support, their missions depend on the financial backing of their donors. With the holidays coming up and the year drawing to a close at last, now is an ideal time for charity-minded investors to think not only about which causes and organizations are closest to their hearts, but also about how to donate in a tax-efficient way.
The process of finding a charity and donating money seems simple. However, just like portfolio asset allocation, slightly different approaches can yield dramatically different results. Let's look at the comparable after-tax benefits of three basic methods of charitable giving.
How much charitable giving is tax deductible?
Before we begin, let's discuss how charitable donations are currently viewed under the tax code. First, charitable donations are deductible only for those taxpayers who itemize deductions. The standard federal deduction for 2020 is $12,400 for individuals and $24,800 for married couples filing jointly.
Second, normally the amount of the deduction is limited to 60% of adjusted gross income (AGI) for cash donations and 30% of AGI for stock. However, investors should keep in mind that this year the government passed the Coronavirus Aid, Relief and Economic Security Act (CARES), which raised the deduction of cash donations to 100% of AGI, to help public charities during the pandemic.
Which method of charitable giving is best?
Cash is a convenient gift because it's easy for donors to write checks for charities to deposit. The gift is also tax deductible in the current tax year. Consider a charitable gift of $50,000 in cash. Assuming the highest marginal tax rate of 37%, the donation can reduce the taxpayer's AGI by $50,000, resulting in a tax bill that's $18,500 lower ($50,000 x 37% = $18,500).
Having a highly appreciated portfolio position is great — until the investor is ready to sell that position. Given a 23.8% federal capital gains tax — which factors in the 3.8% Medicare surtax that applies to high earners — selling highly appreciated positions may be detrimental to investors. A way to completely avoid this liability is donating the stock to charity, which enables investors to make their desired donation, deducts its value from their AGI, and avoids the capital gains tax that gets applied to stock sales.
To analyze the tax benefits of charitable giving, we'll assume the same $50,000 gift amount that we used in the cash example, but instead of cash we'll assume the $50,000 gift consists of securities that have appreciated by 100%, therefore having an initial cost of $25,000. Keep in mind that the IRS allows investors to take deductions from donated securities only if the securities were held for at least one year and the dollar amount sold is less than 30% of the investor's AGI.
The benefit of giving securities over cash is that the investor also avoids the tax liability embedded in the investment. In the example with the securities gift of $50,000, the embedded gain of $25,000 represents a tax liability of close to $6,000, assuming the highest capital gains tax rate of 23.8%. By giving these securities to charity, the investor avoids this capital gains tax. The charity is also free to sell the security tax free, making the gift as good as cash. Similar to the cash gift, the taxpayer in this example also gets a same-year tax deduction of $50,000, which reduces their AGI.
Gifting securities with cash replenishments
In the context of a tax-managed portfolio, investors can realize additional benefits if they replenish their investment portfolio with cash that equals the value of gifted stocks that have appreciated. This manner of reinvesting results in a cost-basis increase that enhances the potential for eventual tax-loss harvesting, which should help reduce future tax payments.
Let's examine a portfolio of $1 million, with $50,000 in securities to gift with a 100% appreciation level in a context similar to the previous example. In this case, however, we'll replenish the portfolio with cash. Given the size of the portfolio and the gift, the cash contribution raises the expected tax alpha by five to 10 basis points. The tax alpha, which is defined as the net after-tax excess return minus the gross pretax excess return, indicates how much better off the portfolio performs on an after-tax basis relative to the benchmark. Much of this performance increase comes from future tax-loss harvesting1 — meaning the incremental tax alpha comes from the expected additional tax losses that will be generated from reinvesting the added cash.
An added benefit of a cash replenishment after gifting securities is that the tracking-error risk of the portfolio can often be reduced by targeting overweight names for gifting and reinvesting in other names, which may lower the overall tracking error.
Bottom line: Charitable giving is an important part of a wealth management strategy. Determining the amount and the specific financial instruments while selecting the path that provides the highest tax benefit can be challenging for many investors. But choosing the right asset manager — one with the expertise, tools and reporting capabilities to help make the important decisions for an investor's portfolio needs — can make all the difference.
Tax-loss harvesting involves certain risks including, among others, the risk that the new investment could perform worse than the original investment and that transaction cost could offset the tax benefit. There may also be unintended tax implications. Investors should consult with a tax advisor before taking action.
Parametric, an SEC registered investment adviser and majority-owned subsidiary of Eaton Vance Corp., provides advisory services directly to institutional investors and indirectly to individual investors through financial intermediaries. Investing entails risks and there can be no assurance that Parametric (and its affiliates) will achieve profits or avoid incurring losses. All investments are subject to potential loss of principal.
Eaton Vance and Parametric do not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. The output of this calculator is for educational purposes only and should not be considered investment, legal or tax advice. It is intended for use by US individual taxpayers resident in the 50 states or the District of Columbia, and is not applicable to trusts, estates, corporations or persons subject to special rules under federal, state or local income tax laws. The indicated tax treatment of investment income and gains applies to positions in securities held outside qualified retirement plans and other tax-deferred or tax-exempt investment vehicles. The output is general in nature and is not intended to serve as the primary or sole basis for investment or tax-planning decisions.
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