- Written by T. Steel Rose, CPA, ACS Editor
Like most aspects of tax law, charitable contributions are rarely a straightforward affair. The simple act of lending a financial helping hand can become riddled with oddities that change from year to year. Disregarding subjective considerations based on your individual tax situation, like if contributing other than cash or to a private foundation, the basic rule concerning contributing cash to a church is 50% of Adjusted Gross Income (AGI). There is also a 5-year carryforward for amounts that exceed the 50%.
If you do not itemize your tax deductions (which normally occurs if you have a mortgage interest deduction) you may not see the full advantage of the charitable contribution. When you cannot deduct a contribution you may choose to contribute directly from an IRA without recognizing the donated amount as income.
Charitable contributions escape alternative minimum tax (AMT) restrictions. While there is a limited advantage to deferring to a non-AMT year, the deduction is not lost. One of the few deductions still allowed under the AMT is a charitable donation. Even if you are subject to the AMT, your charitable contributions will continue to reduce your tax liability. If you expect to be subject to the AMT on a yearly basis, you may take your charitable contributions as deductions, which will reduce your AMT liability, nevertheless.
There was a phase-out of itemized deductions, which itself has been phased out. This was established by Section 68 of the Internal Revenue Code, first added in 1990 during the George H.W. Bush Administration, which established an overall limitation on itemized deductions. This provision was made permanent during President Clinton’s tenure but its effect was limited by President George W. Bush in 2001. Although it was scheduled to expire — or sunset — in 2010, President Obama has proposed keeping it in place and adding another layer of complexity. The following details suggest that Congress has chipped away at itemized deductions rather than abolishing charitable deductions:
When the law was first passed, the AGI limit was $100,000. With inflation indexing, it is now $166,800 ($83,400 for married filing separately).
To calculate the original charitable contribution limitation, you apply all regular limits to individual itemized deductions. That total would be reduced by the lesser of:
(a) 3% of the amount by which AGI exceeded $100,000 ($50,000 for married filing separately), or
(b) 80% of the otherwise allowed itemized deductions. Thus, a taxpayer would get at least 20% of the total itemized deductions.
Assume the original AGI threshold limit of $100,000 on married taxpayers. The couple has an AGI of $200,000 and has the following itemized deductions: $10,000 mortgage interest; $15,000 charitable contributions; $5,000 state income taxes, for a total of $30,000 itemized deductions.
Possible reduction: The lesser of
(a) 3% of $100,000 (the amount by which their AGI exceeds $100,000) = $3,000
(b) 80% of itemized deductions
In this case, (a) above would be the lesser figure–$3,000. Thus, the taxpayers’ itemized deductions for the year would be reduced by $3,000, from $30,000 to $27,000. The final result would be that these taxpayers would have $3,000 more in income taxed at their highest marginal rate.
Note that the limitation does not apply to certain deductions, including the medical expense deduction, investment interest deduction, casualty and theft loss deductions, and gambling loss deductions.
Bush II Softens the Blow
In 2001, the George W. Bush Administration successfully backed off limiting itemized deductions through legislation phasing out the phaseout. The Senate report on the bill gave this reason: “The Committee believes that the overall limitation on itemized deductions is an unnecessarily complex way to impose taxes and that the ‘hidden’ way in which the limitation raises marginal rates undermines respect for the tax laws.”
Tax Year 2010:
The problem with the George W. Bush tax legislation is that it all goes away entirely in 2011, hence the itemized deduction limit reverts to pre-2001 status with the original full 3% / 80% phaseouts back in place.
The Obama budget proposal would reinstate the original 3% / 80% Section 68 limit in 2011. On top of this limit, Obama would limit the resulting itemized deduction benefit to a marginal tax rate of 28% for married taxpayers with AGI over $250,000 and single taxpayers with AGI over $200,000. The effect of this cap is that itemized deductions will not create the same amount of tax savings as they previously did.
A taxpayer who is in the 35% percent tax bracket would normally see a $35.00 benefit for every $100 in itemized deductions. Under the Obama Administration’s proposed cap, that same taxpayer would only see a tax benefit of $28.00 for every $100 in itemized deductions. Coupled with the proposed increase in marginal rates, which under the George W. Bush plan are now scheduled to go back to their pre-2001 levels, the reduction in value can be up to 11.6% (the spread between the top marginal rate of 39.6% and the 28% deduction cap).
From a tax planning standpoint, if you are subject to the AMT in the current tax year but you are generally in a marginal income tax bracket that is higher than the top 28% AMT rate (levied on income that is $175,000 above the exemption amount, $87,500 for married filing separately—the 26% rate applies to income above the exemption amount, but less than $175,000), you may want to consider postponing large charitable contributions to a year when you are not subject to the AMT.
In a non-AMT tax year, your charitable income tax deduction will reduce your tax liability by more than in a year when you are subject to the AMT.