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The Ins and Outs of Tax-Managed Charitable Gifting

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Jeremy Milleson

Director, Investment Strategy

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At a time when many charitable organizations need donations more than ever, learn more about the tax implications of different methods of charitable gifting.

After two straight years of record highs in 2020 and 2021, charitable gifting declined in 2022. In addition to the decline, the negative impacts of inflation have also made it harder for charities to meet their financial goals. As the year winds down and many investors focus on year-end charitable gifting and tax planning, it’s important for investors to give in a way that maximizes donations while reducing the burden of taxes.

In times like these, when there’s such a great need, finding a charity and donating money is relatively easy. However, slightly different approaches to charitable gifting can yield dramatically different results. Let’s look at the comparable after-tax benefits of three methods.

How much charitable giving is tax deductible?

When considering which gifting method might best suit their needs, many investors first ask how donations might affect their tax burden. Charitable donations are deductible only for those taxpayers who itemize deductions. The IRS limits deductions to 60% of adjusted gross income (AGI) for cash donations and 30% of AGI for stock. But as we’ll see, it’s not necessary for investors to make an either/or decision.

For some, bunching deductions may make sense to maximize both gifting and tax benefits. In donation bunching, an investor donates what could be multiple years of planned donations to maximize the tax benefit. For example, investors often use donor-advised funds as vehicles for these donations. With a donor-advised fund, the investor receives an income tax deduction for the fair market value of the securities at the time they are donated (up to 30% of AGI).  However, unlike donating securities directly, the investor maintains control of the assets until contributed to a public charity through a grant recommendation.

Which method of charitable giving is best?

Gifting cash

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).

Gifting securities

With the S&P 500® up 13.07% for the year through the third quarter and an annualized return of almost 12% over the past 10 years, many portfolios likely include a lot of appreciation. Having a highly appreciated portfolio is great, until the investor is ready to sell some of the portfolio. 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. One way to completely avoid this liability is to donate the stock to charity. This enables investors to make their desired donation, deduct its value from their AGI, and sidestep the capital gains tax applied to stock sales.

To analyze the tax benefits of gifting securities, we’ll assume the same $50,000 gift amount from 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 gifted is less than 30% of the investor’s AGI.

The potential benefit of gifting 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 gifting 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

On top of the benefits of gifting highly appreciated securities instead of cash, investors with a tax-managed direct indexing portfolio can potentially realize additional benefits if they replenish their investment portfolio with cash equal to the value of gifted stocks. This manner of reinvesting could result in a cost-basis increase that may enhance the potential for tax-loss harvesting, which could help reduce future tax payments. 

Let’s examine a direct indexing 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 could potentially raise the expected tax alpha—the net after-tax excess return minus the gross pretax excess return—which indicates how much better the portfolio performs on an after-tax basis relative to the benchmark. 

The portfolio manager can often reduce the tracking-error risk by targeting overweight names for gifting and reinvesting the cash in other names, creating the added benefit of a cash replenishment after gifting securities in a tax-managed direct indexing portfolio and lowering the overall tracking error.

Charitable gifting methods by the numbers

Charitable gifting methods by the numbers

Source: Parametric, 10/31/2023. For illustrative purposes only. Does not reflect the experience of any investor and should not be relied on for investment decisions. Parametric and Morgan Stanley do not provide legal, tax, or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction.

The bottom line

Charitable gifting can have a large impact on the philanthropic landscape and should be an important part of a wealth management strategy. Determining the amount and the specific financial instruments can be challenging for many investors. Selecting the path that maximizes potential gifting and provides the highest tax benefit while still aligning the portfolio with the investor’s selected benchmark can be difficult. But choosing the right asset manager—one with the expertise, tools, and reporting capabilities to help make the important decisions for your clients’ portfolio needs—can make all the difference.

Parametric and Morgan Stanley do not provide legal, tax, or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein.

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