Should you donate via credit card? It’s complicated.
It’s a bad idea for most people
My first reaction is frustration when I hear about people donating to their church via credit card. Credit cards charge high transaction fees: a common rate is 2.9% of your donation plus a $0.30 fixed fee. While convenient, it’s a very expensive way to transfer funds.
You might protest that you want to earn credit card points / rewards. For most purchases, I would enthusiastically agree. I’ve got the Wells Fargo Active Cash card that earns me 2.0% cash back with no annual fee.
But here’s the problem: If you give $100 on your card, the church might pay $3.20 so that you can earn $2.00. Said another way, it cost you a net $98.00 to give away $96.80. You just wasted $1.20.
Alternative #1: If your desire is to net the church $96.80, just write a check for that amount. You can keep the “extra” $1.20 for yourself.
Alternative #2: Write a check for $98.00. You are indifferent to this and the credit card scenario, and the church keeps the extra $1.20. Better for the church to have it than the banks.
Alternative #3: Split the $1.20 with the church and write a check for somewhere between $96.80 and $98.00.
Donating via a credit card is suboptimal and inefficient for most Americans. A much better solution is a direct ACH transfer or an old-school check (yes, apparently they still exist).
But it turns out that this isn’t always true.
Tax arbitrage anyone?
As an example, let’s consider “the Smiths” - a high-earning couple from California. They want their church to receive a net $1,000 and want to do so in the most efficient manner possible. They are in the 32% federal tax bracket and the 9.3% state tax bracket. Additionally, they plan to itemize deductions and have a 2.0% cash back credit card. Their church has negotiated terms of 2.20% + $0.30 for processing credit card donations.
Option 1: Write a check (for $1,000)
Church: No transaction costs are incurred for check deposits. The church receives a net $1,000.
The Smiths: While initially out the $1,000, they receive a tax deduction for their donation. Since CA allows this to also be deducted on the state return, the tax rebate is 41.3% (=32% + 9.3%), or $413. Thus, the after-tax cost of the donation is $587.00.
Option 2: Donate via credit card ($1,022.80)
Church: To cover the credit card fees, the Smiths gross-up their donation and donate $1,022.80. The church pays $22.80 of fees (=$1,022.80 * 2.20% + $0.30). They net $1,000 – equivalent to option 1.
The Smiths: The tax benefit is now calculated on a higher gross amount and increases to $422.42. Additionally, they get $20.46 in tax-free cash back from their credit card rewards. Netting both these rebates against the initial outflow results in an after-tax cost of $579.93. This is $7.07 cheaper than option 1 (or 0.69% of the gross donation amount).
Illustrative scenario where credit card giving is optimal
Wait, what? How can it be more efficient for the Smiths to utilize the highly inefficient and expensive credit card system?
Key Insight: The IRS generously splits the cost with you (the fees) while letting you keep the full benefit (the credit card rewards).
Sharing the cost with the IRS: The full value of the (gross) charitable donation is tax-deductible. So the Smiths are really splitting the cost of the $22.80 fee with the IRS. By increasing their donation by this amount, they increase their tax benefit by $9.42. Thus, the net processing fee the Smiths incur is $13.38 (=$20.80-$9.42). This yields a net fee of 1.31% paid by the Smiths to utilize their credit card.
Keeping all of the benefit yourself: The $20.46 in cash back rewards from the credit card company is tax-free. (This is important. If this were taxable income the result would no longer hold.) This means that the Smiths keep 100% of the benefit.
Combining the two, from the donor’s perspective the benefit outweighs the cost by $7.07.
If the Smiths give $20k for the year, the incremental benefit is $145 (vs writing a check). They can enjoy a nice dinner out courtesy of the IRS.
Sources of Value
If you are itemizing, the amount of tax arbitrage available (if any) is primarily driven by 3 main factors:
Marginal tax rate – the tax benefit you receive increases as you move into higher tax brackets (and/or live in a state that has an income tax and allows charitable deductions to be deducted.)
Variable processing fee – the lower your church’s fee to the credit card companies the better. It gives you an easier ‘hurdle’ to clear.
Credit card rewards rebate – The higher the better (assuming it doesn’t increase the fee the church pays, like using an Amex sometimes does.)
There are 2 other inputs, but they matter a lot less. The first is the fixed processing fee - this is relatively small and will be increasingly diluted as the size of the donation increases. The second is the size of the targeted net donation. This is the driver that can dilute the fixed fee. (If there were no fixed fee, then the arbitrage percentage would be identical for all donation sizes.)
Let’s quantify the arbitrage for varying levels of tax rates and variable processing fees. I’ll use a fixed fee of $0.30 and a net donation of $1,000.
Tax arbitrage when earning 2.0% rewards
In this scenario, there are many situations where it isn’t possible to create positive tax arbitrage (red cells above). The maximum benefit is ~1% in situations where a donor in a high marginal rate gives to a church with a relatively low processing fee.
Tax arbitrage when earning 3.5% rewards
No card will give you 3.5% over the long-term. But you might be able to find one offering 2.0% plus a $300 sign-up bonus if you spend $20k (mathematically equivalent). The Smiths from our example above would save $450 on their $20k donation in this case.
Or perhaps you have other credit card hacks that get you benefits that you value at or above these cash equivalents (e.g. travel perks, etc.)
You’ll also note that at these high rewards rates, there is some arbitrage to be earned even without any tax subsidy on donations (i.e. opening the door for those taking the standard deduction). This is because the reward rebate on its own is sufficient to cover the processing fees in these unique – and likely rare – examples.
Conclusion
In practice, itemizing deductions is likely a prerequisite for credit card giving to make sense. The Tax Cuts and Jobs Act of 2018 raised the standard deduction significantly. With this change, only 10% of filers itemized in 2020. For most people the initial intuition holds: giving via credit card is likely a bad idea.
For small segments of the population, giving via credit card could be superior to writing a check due to tax arbitrage. For the stars to align the donor needs to itemize, face a high marginal tax bracket, earn a robust rewards rate from their credit card, and donate to an organization with relatively low processing fees.
While potentially superior to writing a check, using a credit card still might not be the best option (more to come in a future post on donating appreciated securities).
Finally, if you do decide to donate via credit card, make sure to do two things first:
Talk to your charity and find out what processing fees they incur (and potentially help them get lower rates!)
Increase your donation to cover these costs (vs the amount you would be willing to write a check for). You don’t want the charity to suffer in your quest for tax arbitrage.
Postscript
I love financial situations when one’s initial (logical) intuition turns out to either be wrong or incomplete. Sometimes you need to do the math!
For the ultra-nerdy (like me?), I worked out the analytical solution for the amount of tax arbitrage available based on a donor’s individual situation below. Don’t worry - nothing more than algebra here!
