Time to Read: 9 Minutes
Many charitable individuals want to know the most tax-efficient strategies for donating to their favorite causes. In Part 2 of a 7-part series, “Tax-Saving Strategies for High Earners,” we evaluate the unique tax benefits of a Donor-Advised Fund (DAF), a charitable giving account designed to help taxpayers receive large immediate tax deductions, reduce capital gains, and give to charities according to their own timelines.
A DAF is a tax-advantaged personal investment account funded with assets that will ultimately be given to charity. These assets can be invested in the DAF and grow tax-free. You can fund a DAF with multiple years of charitable contributions, receive a large upfront tax deduction, and retain discretion over when assets in the DAF will be distributed to charity.
DAFs accept contributions in various forms. Mutual funds, exchange-traded funds, individual stocks, bonds, real estate, LLCs or limited partnership interests, and in some instances, even life insurance can be donated to a DAF. While taxpayers most commonly think to contribute cash, a greater tax benefit may be achieved by donating some of these other assets, even for those who’ve set aside cash to give or do not want to rid themselves of good investments.
Given that tax laws related to charitable giving frequently change, it’s important to discuss charitable giving strategies with your CPA before making any donations. We also suggest contacting the financial institution where your DAF is held to verify if the assets you’d like to contribute will be accepted.
Although you can contribute as much as you want to a DAF, creating a strategic funding strategy may help maximize your tax benefit and avoid certain IRS tax-deduction limits. In general, the IRS allows individuals to receive an itemized tax deduction for charitable cash contributions up to 60% of their Adjusted Gross Income (AGI), and non-cash contributions up to 30% of their AGI. Any unused tax deductions from contributions exceeding AGI limits may be carried forward for a maximum of five years. Although the IRS has a more generous tax-deductibility limit for cash contributions, giving cash is typically less tax effective than giving other assets, such as appreciated stock.
To learn more about the tax deductibility of your charitable gifts, you can refer to the IRS publication on Charitable Contribution Deductions and use its Tax Exempt Organization Search to see if your favorite charities are considered IRS qualified.
Donating appreciated investments to a DAF can provide multiple tax benefits. First, you may receive a tax deduction equal to the current market value of the investment contributed, subject to certain limits and restrictions. Second, if you still want to own the investment you contributed to the DAF, you can just rebuy it at its current price. Now you own the same investment but have rid yourself of its previous unrealized capital gains.
Third, assets invested in a DAF grow tax-free and can be distributed to charity at the donor’s convenience. No taxes are due if the investments in the DAF earn dividends, pay interest, or are sold for a gain. In short, once you contribute assets to a DAF, you no longer need to worry about paying taxes generated by the investments you donated.
In this simple example, suppose that John purchased ABC stock for $50 per share two years ago. Today the stock is valued at $150. If John were to sell ABC at its current price, he might be subject to a capital-gains tax on the stock’s appreciation of $100 per share ( $150 current price less his $50 purchase price).
Rather than sell ABC stock and donate the proceeds to charity, John decides to transfer his ABC stock in-kind to a DAF. By gifting stock directly to a DAF, he may receive an itemized tax deduction equal to $150 per share of ABC stock donated, and owe no capital-gains tax on the stock’s growth. If John would still like to own ABC stock, he could re-buy it at today’s price with the cash he otherwise would have given to charity. Now he owns the same investment without any unrealized gains and may receive the same itemized tax deduction he would have received had he donated cash.
As discussed in Tax-Saving Strategies for High Earners: Part 1 – Stacking, when filing your tax return, your taxable income will be reduced by the greater of the sum of your itemized deductions or the flat standard deduction. Since the Tax Cuts and Job Act of 2017 nearly doubled the standard deduction and imposed stricter limitations on itemized deductions, fewer taxpayers are benefiting from itemized deductions for their charitable giving.
To potentially increase the overall tax benefits for charitable giving, a DAF can be used to frontload multiple years of tax deductions from charitable donations into a single tax year to push itemized deductions over the standard deduction threshold. Charitable, high-income households with itemized deductions just under the standard deduction threshold may want to consider using a DAF to facilitate a large upfront tax deduction for charitable giving. The increased tax benefits of frontloading charitable contributions are demonstrated in the example provided in Part 1 – Stacking.
Contributions to a DAF can be more valuable during high-income tax years because the tax-deduction limit for charitable donations increases with income. The following hypothetical scenario describes another household that may benefit from frontloading charitable contributions.
The Smiths are high earners who give $30,000 to charity per year and will retire at the end of the year. While their AGI is $450,000 this year, it will drop to $150,000 per year in retirement.
Before year-end, they decide to frontload three years of charitable contributions into a DAF by transferring appreciated assets in-kind from their investment account. With an AGI of $450,000, the Smiths receive the full $90,000 ($30,000 charitable donation x 3 years) itemized tax deduction in the year their donation was made because it was under the 30% AGI threshold of $135,000 ($450,000 AGI x 30%) for non-cash charitable contributions.
If the Smiths had waited until retirement to fund their DAF, the tax deductibility of their $90,000 charitable contribution would have been limited to $45,000 ($150,000 AGI x 30%). As a result, $45,000 of unused tax deductions would have been carried forward for up to five years. Given that the Smiths will be in a lower income-tax bracket during retirement, their remaining tax deduction for charitable giving would have been less valuable in future years.
For instance, suppose the Smiths pay taxes at an average rate of 35% before retirement. A $45,000 itemized deduction for charitable giving may produce overall tax savings of $15,750 ($45,000 itemized deduction x 35% tax rate). If their average tax rate drops to 24% in retirement, the same $45,000 itemized deduction will only produce $10,800 ($45,000 itemized deduction x 24% tax rate) in tax savings.
Although it’s simple and convenient to make cash contributions to your favorite charities, a more tactical charitable giving strategy may help increase your overall tax benefits. This can mean greater upfront tax deductions, avoidance of capital gains you would have otherwise paid, and receiving larger tax deductions in high income-tax years.
As part of our service to clients, Stratos Private Wealth utilizes a tax-focused financial planning tool that analyzes prior years’ tax returns to uncover potential tax-saving strategies, such as stacking charitable contributions into a DAF.
While we are not tax advisors, we can work directly with your CPA to determine how much you can afford to give to charity, identify which assets to donate, and evaluate in which years charitable giving will most likely provide the greatest tax-savings opportunity.
If your CPA recommends funding a DAF, we can also help you determine an appropriate asset allocation based on risk tolerance, how long the funds will be invested in the DAF, and your goals for distributing assets.
If you need help identifying tax-saving opportunities, please reach out to Stratos Private Wealth. We will provide high-level advice that can be evaluated by your CPA and then be put into action.