Donating Appreciated Investments: A Powerful Tax Saving Strategy

July 8, 2018

Investing, Stocks, Taxes

You can’t fight city hall, so how do you win against the much bigger Federal and State Governments? Bentzy Verschleiser paid a hefty share of his $200,000 in businesses income as taxes to these “partners.” Now, although he was excited about his eldest daughter’s upcoming wedding, it seemed like it would cost him an additional $7,000 in taxes!

For many years, Bentzy had been investing $100 monthly per child into stock mutual funds to cover the cost of their weddings and related expenses. His daughter’s pot was now worth $60,000, but his accountant had said that when Bentzy sold the stocks, he’d owe $7,000 in federal and state taxes on the profit portion of it (not on the principal).

How can Bentzy cash out his mutual funds to pay for his simcha without having to pay any tax on the gains?

Saving While Donating

While the tax collectors usually do win no matter what, there are some tax bargains out there for those who plan carefully. Bentzy can use one of them, charitable donation of appreciated investments, to avoid any tax on his mutual funds’ profits! This strategy enables people who are giving tzedakah anyway, thereby getting a mitzvah and an income tax deduction, to save even more on their tax liabilities, a triple financial win. This concept is based on the following straightforward tax facts: 1. Investment profits are not taxed until you cash out and put them in your pocket. 2. Investment profits that are donated (and therefore never put in your pocket) are not taxed at all.

Investment Profits Aren’t Taxed Till Cashed Out

To encourage people to invest their money and grow the economy, investment profits get favorable treatment by the IRS. The most obvious beneficial treatment given to capital gains (investment growth) is a lower tax rate than that of salaried ordinary income. Whereas the government takes about 30% of Bentzy’s salary for its income tax share, his tax rate for capital gains is “only” 21%. Also, capital gains are taxable only after the investment is sold and the profits locked in. As long as your investment’s gain or loss is just a number on paper, it’s ignored for tax purposes. This makes sense because until an investment is sold it’s unclear how much of a gain or loss you had (not including any dividends or interest taken in).

Donated Investment Profits Are Tax-Free

Charitable donations are also supported by the tax laws; contributions are tax-deductible. When Bentzy donates 10% of his $200,000 salary to tzedakah, he deducts the $20,000 in donations from his taxable income and owes tax only on the remaining $180,000. This saves him about $6,200 a year in taxes ($20,000 x 31% ordinary income tax rate). But a lesser-known tax benefit is that when someone donates an investment that has gone up in value directly to charity (without cashing out profits), there is no tax owed on the accumulated gains. Therefore, if Bentzy donates $20,000 of mutual funds to tzedakah, he will not owe tax on any of the investment’s gains. This capital gains tax benefit, worth $2,500 to Bentzy, is added on top of the regular tax-deduction benefit (worth about $6,200 as noted before). Donating appreciated investments is therefore a double tax win: 1. the regular tax deduction plus 2. avoidance of any tax on the capital gains.

Putting It All Together

By shifting his charity donations from cash to mutual funds, Bentzy can sell his investments tax-free and have the funds available to pay for the wedding and ongoing support. Bentzy should pay his $20,000 in ma’aser using his mutual funds instead of writing checks from his regular accounts. Signing a simple form allows his broker to gift the mutual funds directly to a charity’s brokerage account; organizations can open accounts to accept these investments very easily. The charities will sell the mutual funds, and as not-for-profits, won’t owe any tax either. (Alternatively, he can place them into donor-advised funds and have the funds send checks to the tzedakah organizations.) Since his charity is coming from the sale of his mutual funds rather than his bank account, the necessary money for Bentzy’s simcha has been freed up tax-free!

Donating appreciated investments is, therefore, actually a win-win-win situation. The tzedakah organization, of course, wins by getting a donation. The second win goes to Bentzy when he receives the tax deduction for donating to charity. And finally, by avoiding capital gains tax, he is a winner once again. This excellent maneuver can be done on a consistent basis, regardless of weddings, by annually donating (into a donor-advised charity fund) appreciated stocks up to the amount of your intended tzedakah giving and then paying all tzedakah out of that account. The same strategy can also be beneficial to help lower-income families protect their earned income tax credit (by continually shifting their investment gains to charities instead of taking it themselves). And don’t feel sorry for paying no tax on your investments; to paraphrase Donald Trump, this just means you’re smart.

Note: Please discuss any tax planning with your accountant.