Tax Efficient Charitable Contributions

This time of year is actually Tax Time for my father. I won't bore you with details (and honestly, there's only so much a 2.5 year old knows about taxes, so please don't treat this post as tax advice you can rely on), but he files for an extension every April and submits his final tax return in October every year.

Part of the reason we get to travel so frequently is because my father is smart about taxes. After all, the points/miles from frequent flyer programs, hotel loyalty programs and credit cards are tax-free rewards because they're treated as rebates.

Basic Example
Think about it this way. Let's imagine that Mickey paid $300 for a flight to Orlando. He was using after-tax money, so that flight really cost him about $400 of Mickey's pre-tax income (assuming he pays about 25% in state and federal taxes).

Donald, on the other hand, won a contest where he was given a free round trip ticket to Orlando. The value of that ticket was $300 (same as Mickey's ticket), but because he won it as a prize, the IRS will come asking him to recognize that value as earned income, thus he will have to actually pay $75 in cash for taxes on that "free" prize (assuming that same 25% total tax rate).

However, Minnie had enough frequent flyer miles to pay for the exact same flight to Orlando. First, those miles are treated as "rebates" (i.e., discounts), so they're not taxed as income when she receives or redeems them. Second, while Minnie saved $300 in cash by using her miles, she actually could have earned $400 less at her job and been financially equivalent to Mickey. Smart girl that one!

Charitable Donations
There's also a few other clever (but 100% legal) ways to reduce your tax hit every year. Here's a few background points to keep in mind to understand how this works:

• Charitable Donations are not for lowering your taxes. They're for helping organizations and causes that resonate with your heart.
• However, if you're going to make a charitable donation anyway, then you can lower your tax bill by taking a Charitable Donation Deduction to reduce your Adjusted Gross Income. 
• If you sell any stocks that increased in value from the time you bought them, then you will likely have to pay taxes on that gain.

Imagine Daisy has 1 share of stock worth $100 today that she bought 3 years ago at $70. Because she recognizes how fortunate she is being healthy and employed, she wants to give back to those less fortunate and make a donation to her favorite charity. 

She has several options to choose from: (A) make a $100 cash donation, (B) sell her stock and then use that cash to make a $100 cash donation or (C) donate the share of stock directly to the charity. 

Option A

• A deserving charity will get $100 more dollars to help delivery their mission.
• Daisy will lower her Adjusted Gross Income by $100. Assuming the same 25% tax rate, she will lower her taxes by $25.
• Daily will still own the stock, and it can go up/down over time. But whenever she does sell it, she will owe taxes on any gain.
• So her tax benefit is $25 less any future capital gain tax.

Option B

• A deserving charity will get $100 more dollars to help delivery their mission.
• Daisy will still lower her taxable income by $25 initially.
• She will also be hit with a Capital Gains tax on the $30 gain on her stock ($100 selling prices less $70 purchase price). Assuming a 15% rate, she will pay an additional $4.50 in taxes.
• Daisy will keep the $100 in cash, but will no longer own the stock as she has sold it.
• So her net tax benefit is $20.50 with no future tax liability.

Option C

• The charity still gets $100 to help them. It will likely sell the stock and convert it to $100 cash.
• Daisy will still lower her taxable income by $25 (no strings).
• Daisy keeps $100 in cash, but will no longer own the stock as it was donated to the charity.
• However, because it was donated to a charity (and not actually sold), Daisy will not have to pay any taxes on the historical $30 gain.
• So her tax benefit is $25 with no future tax liability.

Clearly Option C appears to be the best strategy for Daisy from a tax standpoint.

FAQ

"But Option A she gets to keep the stock. Isn't that better in case it continues to go up in value?"

Good point! Well, that brings up Option C2 - donate the share of stock directly to the charity AND use the $100 cash to buy back a new share of that same exact stock.

• The charity still gets $100 to help them. It will likely sell the stock and convert it to $100 cash.
• Daisy will still lower her taxable income by $25 (no strings).
• Daisy uses that $100 in cash to buy-back the stock she donated to the charity.
• However, because it was donated to a charity (and not actually sold), Daisy will not have to pay any taxes on the historical $30 gain.
• So her tax benefit is $25 with no future tax liability on the original $30 stock price gain.

"But what's the point of doing all that if she is still out $100 cash and has that same share of stock. Isn't that the same thing as Option A?"

Not exactly. Yes, Daisy is still out $100 cash. Yes, she still owns the stock. But now, she owns the stock at a new $100 purchase price (cost basis), and any future gain will be calculated using the higher $100 purchase price. So that $4.50 tax (15% on the initial $30 gain) is completely eliminated from the equation.

"I've heard of something called the Wash Sale Rule against selling a stock and buying it back immediately for tax reasons."

Very good point, but that actually applies only for sneaky individuals looking to sell at a LOSS. Those tricky traders are trying to both (a) realize stock losses to offset other income or gains and (b) buy-back that stock to benefit from any future price increase. That way, they would get an immediate tax benefit and still own the stock (albeit at a lower cost basis).

However, because Daisy is selling at a GAIN, there's no tax evasion. In fact, you're realizing a taxable event where you pay taxes. But, of course, because the stock was donated to a charity, that tax is waived.

"Big deal, she saved $4.50."

Well, yes, at 1 share worth $100, the tax implications seem pretty small. However, in reality, individual donors are often making 10-100x the size of this donation, so that $4.50 in tax savings can quickly become $45-450. And further, many smart investors bought today's $100 stocks at just $1 years ago, so that's 15% of a much bigger capital gain...

So as we get closer to next month's October 15 Tax Return Filing deadline, my father is actually getting excited about actually receiving some money back from the IRS.

More to put into our 2015 Vacation Fund!