Congress passed its tax reform bill last December with the title “Tax Cuts and Jobs Act.” For most families the tax cuts part of the title will be true thanks to lower tax brackets. The other boon to taxpayers, especially to middle income earners, is the increased standard deduction. In 2018 it nearly doubles to $24,000 for couples. This will cause a marked decrease in the number of families for whom it makes sense to itemize deductions. Today we explore how this change might have unintended consequences over the coming years.
In 2015, the most recent year for IRS statistics¹, less than 30% of households itemized deductions. In our experience, the most impactful itemized deductions are mortgage interest, state and local taxes, large medical expenses, and charitable donations. For those 30% of households that expected to itemize, most think of these expenses on an after-tax basis, e.g. a charitable donation only costs 55¢ on the dollar. This is a reasonable thought process and one that has benefitted charities. Taxpayers are excited to exercise some control over their dollars by funneling them away from the tax coffers and into their favorite non-profits.
Beginning the 2018 tax year, there will be substantially fewer families following this thought process. There is not great public data that predicts how many households will itemize, but given how right-skewed our income distribution is, it’s not unreasonable to think that as little as 10% of filers will itemize in the future. If there are more families at lower income levels, a doubling of the standard deductions should more than halve the families who itemize.
Whatever the number turns out to be, it will definitely be less than the 30% who used to itemize. Some number of taxpayers will be faced with a reduced incentive to give. They will “lose” their charitable deduction if they don’t have enough expenses to itemize. Any non-profit director can confirm that most giving happens at the end of the year when taxpayers have the best idea of how giving can affect their tax picture. I fear that for this slice of taxpayers, their charitable intent will prove to have been only part of their motivation to give, and they will reduce or eliminate annual donations.
For such a family on the edge of itemizing, it may be beneficial to make lump sum donations. Take a family that in the past donated $500/month and had itemized deductions of $20,000. If they instead saved those donation dollars for the first year, in year two they could donate $1,000/month. That would put them into itemizing territory and let them benefit from some of their giving.
There is one piece of the reform that may combat this problem- the limit on deductions. Formerly taxpayers were able to take a charitable deduction of up to 50% of their adjusted gross income. In 2018 this increases to 60%. This is great news for charities, as it may accelerate giving from high income households. For example, an executive with a $500,000 income planning to retire next year may like to maximize donations this year while they have the greatest tax benefit, knowing that income will decrease in retirement. In this case, she would be able to deduct $50,000 more than with the 2017 rules.
It will be interesting to see the effects of tax reform on giving in the coming years. In our practice we have found that our most generous clients are also the happiest. We are always here to help facilitate giving. We are thrilled when we get to brainstorm creative giving strategies that help our clients’ favorite causes. If you ever need help examining your giving, please don’t hesitate to reach out.