50% every 5 years > 10% every year
As I meet more EAs, I’m surprised at the number who donate 10% annually. I share their bias and preference to give now, although I acknowledge there is a somewhat-convincing argument for investing now and giving later. (I’ve overcome this objection by seeking out donation matching opportunities.) Whatever you reasoning, if you prefer to give now, you really should consider giving a larger amount every few years (up to 50%), instead of giving 10% annually. I’ll explain why below.
In the US the standard deduction is $6,500. In my understanding, this is a number the IRS uses to prevent paperwork, trickery, and oversight of deductions. Assuming you make around $70,000 per year and donate 10%, only ~$500 of your donation will be tax exempt. This assumes you had little to no other deductions, which is a reasonable caveat for most of life.
Have you ever wondered why EAs seem to fall into two groups? Those who give 10% and those who give 50%? I don’t believe it’s because those who give 50% are 5 times as generous. I believe it’s because once you get above $6,500 in deductions + donations, each additional dollar costs only about $.66 to donate. More simply, donating a larger percentage becomes less expensive.
The full math is pedantic, but I trust you to understand and restate this point: For each dollar you give above $6,500 (minus your other deductions), you will receive a tax refund of approximately 35% (though the exact percentage varies based on your tax bracket). Generally, the more income, the higher your bracket. In my experience, the size of my refund has actually been about 50% of my total donations, though like I said, this will vary based on your other deductions and gross income.
After receiving your first large refund check, you’ll want to plan ahead—because money now is better than money later. If you increase your exemptions on your W4, your refund will be smaller, but you’ll get to keep more of your paycheck, and your net income after taxes remains the same. There is a handy tool on the W-4 to determine how many exemptions you should claim based on your expected donations. For 50% of income, I remember the exemptions being ~10.
Lots of people in the US are already itemizing their deductions for another reason, like having a mortgage on a house, in which case optimizing which year you donate doesn’t matter.
I also expect donating at least once a year to be much better from a practice of maintaining motivation. I’ll often advocate people in this situation use a two-year schedule where they donate at the beginning of January and the end of December half the years, and not at all in the other half of the years, mentally classifying this as “making their annual donation”.
The December and January donation idea is a great solution. Also, touche’. This wouldn’t apply to people itemizing due to other deductions like a mortgage.
Also, three of the largest EA states (CA, NY and MA) have high enough state taxes that it becomes worth itemizing around $100k of income for that alone.
(I may have gotten the January/December thing from your post; not sure.)
Finally I’ve realized:
My future giving could potentially be greatly aided by an accountant.
This is a good thought—we definitely should try to use donations to reduce taxes—but as John points out, you can deduct more if you make your deductions in a higher tax bracket. If you don’t have a lot of itemized deductions, you should probably donate every two years.
Interesting observation. However, I think it’s a bit more complicated than you make it out to be. Let’s say I’m a very high earner and the standard deduction is tiny compared to my total income. If I give 10% each year, that 10% would have been taxed at a very high marginal rate. If I give 50% in a given year, the first 40% of that 50% would have been taxed at a comparatively lower marginal rate, and thus I get a smaller total refund.
The best strategy might be giving 30% every 3 years or something like that.
The argument also doesn’t work if you have good reasons not to take the standard deduction, e.g. enough kids and other things you get tax breaks on.
I believe there’s a space to write the amount of money you plan to donate on your W-4, although it’s on the back of the sheet or something like that (the HR person at the last company I worked at wasn’t aware of it).
Good point, the best strategy will vary based on income. I guess getting above that $6,500 is the first hurdle.
Am I correct in thinking that under the UK tax system the consideration you have outlined in your post does not apply (because we do not have a standard deduction if I understand correctly), and in fact the opposite becomes true once you hit the higher tax bracket for the reasons outlined by John_Maxwell_IV above? If you are not earning above the higher tax bracket then the two approaches would be equivalent?
Neil I believe that’s true for the UK. For two reasons
No such thing as a standard deduction
Donations up to the higher tax threshold are not ‘deductible’ but the 20% tax paid on these pounds goes to the charity as an extra donation.
It’s only above the 20% tax rate (higher tax bracket) that you get a refund (if you pay the 40% rate you get 20% back and 20% goes to the charity as above).
So this approach would be counter productive if you earn moderately above the higher tax threshold. The exception would be if you earn so far above the higher tax bracket that donating 50% every 5 years would leave you above the higher tax bracket threshold that year. (However in that case you should probably be donating more than 10% pa ;) )