Around this time of year, you often hear about how a making charitable donation can help lower your taxes, but how exactly does that work? Let’s take a high level look.
The Contract of all Contracts – The Tax Code
The first thing to understand is the tax code. You can visualize the tax code as a contract that is written by tax authorities between the U.S. Government and its citizens. It is a single contract that applies to everyone universally. Once it is set, citizens have to abide by it, but it is large and complex and lawyers and advisers help clients pay as little in taxes as possible. This is referred to as tax planning.
One item in the contract pertains to charitable donations. Basically, the government says, if you want to give money to an accredited charity during the year, as long as you are generating income from your activities during that same year, the government may chip in a portion of that donation in the form of a tax reduction.
Standard vs. Itemized deductions
The standard deductions for 2017 and 2018 are listed below. As you can see, the standard deduction will increase significantly in 2018.
The Math of Charitable Contributions
Earlier, I said the government may chip in because of the standard deduction. The logic is a filer takes the greater of two numbers – the standard deduction or itemized deductions.
If you take the standard deduction, then whether you donated to charity does not matter. On the simplified tax form below, let’s assume you have $100,000 income and itemized expenses of $8,000. Since it is smaller than the standard deduction, you would take the standard deduction and pay $21,825 in taxes at 25% on the gross income.
If you donated a marginal $100 to charity, you would still take the $12,700 deduction and nothing changes to your tax bill. It wouldn’t make sense for you to itemize your transactions and add $100 to your deductions. Doing so would result in taxes of $22,975, $1,150 more in taxes paid.
|Status Quo||Charity Donation||
|Taxes @ 25%||-23,000||-22,975||-21,825|
Now if your itemized deductions exceed $12,700, then you would take the greater number. On the simplified tax form below, let’s assume you have $100,000 income, itemized expenses of $25,000, and pay taxes at 25% on the gross income. If you give $100 to charity, you get to add it to your itemized deductions. This reduces your gross income by $100, and your taxes paid decreases by $25.
|Status Quo||Charity Donation||Difference|
|Taxes @ 25%||-18,750||-18,725||-25|
Basically, the government is saying if you want to make a $100 charitable donation, it will give $25 and you give a net $75. However you have to give the $100 up front and submit documentation to be reimbursed $25 at a later date. If you don’t submit your documentation then you haven’t lived up to the terms of the contract and the government doesn’t chip in its $25 share to the charity.
Put another way, you have lent the government $25 and you need to show it proof that it owes you the money. If you don’t provide the government with proof, then it won’t repay you the money it has borrowed.
This is a simplified and illustrative example. In practice, tax brackets come into play. Your actual savings would depend on which tax bracket a marginal charitable donation falls into.