A donor-advised fund (DAF) is like a charitable investment account with the sole purpose of supporting organizations you care about. When you contribute cash, securities, or other assets to a DAF, you are generally eligible to take an immediate tax deduction. Those funds can then be invested for tax-free growth and you can recommend grants to virtually any IRS-qualified public charity.
These charitable-giving options offer ease and convenience for the right type of donor, so let’s take a look at some of the benefits of implementing this strategy.
Maximize your tax savings
Thanks to the changes in the standard deduction as a result of the Tax Cuts and Jobs Act (TCJA) passed at the end of 2018, fewer people are itemizing their deductions these days. In fact, it’s estimated that 90% of taxpayers will simply take the standard deduction. For those that claim the standard deduction, the additional tax benefit for making a charitable donation is limited to $300 for individuals and up to $600 for joint filers for 2021. A DAF, however, can lump multiple charitable contributions into one tax year to achieve a deduction. Let’s look at the following example:
Maria is a law associate with a salary of $100,000. Currently, she’s trying to save for her first home, so her only deductible expenses for federal tax purposes are $10,000 in state and local income taxes and $2,000 in gifts she makes directly to charities, for a total of $12,000. Because the standard deduction in 2021 is $12,550, she would claim the standard deduction on her tax return. Instead, if Maria opens a DAF and allocates $4,000 to fund two years’ worth of charitable gifts, her total deductions would be $14,000. At her income level, she falls into the 24% federal tax bracket, saving her $348 in federal taxes. By repeating this process of adding $4,000 to the DAF every two years, Maria stands to save $1,740 in taxes over the next decade.
Lumping multiple years’ worth of charitable gifts into one year also makes sense for donors that expect their income to drop in future years, either because they received a one-time bonus or are planning to retire.
Again, using Maria’s situation in the previous example, let’s now assume 30 years later Maria is a partner with her law firm with an income of $400,000. She plans to retire next year so her income will drop significantly. Currently her marginal federal tax bracket would be 35%, but would drop into the 22% bracket the following year. If she decides to put five years of contributions in her DAF for a total of $10,000, this saves her $3,200 in taxes. If she had made annual $2,000 donations, her tax savings would be lower ($2,460) because of the drop in her income tax rate.
Flexibility on when and how to distribute grants
Once you donate assets to a DAF, you don’t have to allocate them to a charity all at once, which is helpful if you are unsure which charities you’d like to support. Any funds that remain in the DAF can be invested and grow tax-free until you want to make a contribution. This means there’s an opportunity to grow these assets over time with a well-managed plan. Any gains made with your funds will remain tax-free and can then be distributed to charities of your choice when you’re ready.
Avoid capital gains on appreciated assets
In addition to cash, a DAF can also accept publicly traded securities (stocks, bonds, mutual funds, ETFs, etc.), as well as private business interests, cryptocurrency, and private company stock (check with the sponsor to determine what assets they will accept). If you sold these securities, you would pay capital gains taxes on the increase in value (generally 15% for most tax brackets, but it can be as high as 20% for the highest tax bracket or 28% on collectibles like gold, art, etc.). However, once these assets are inside the DAF, they can be sold for cash, avoiding the capital gains tax and allowing 100% of the proceeds to either be reinvested or distributed to a charity.
While appreciated non-cash assets often are the most tax-smart charitable gifts, not all charities have the capability to accept them. Many smaller charities, such as homeless shelters and food pantries, might not be able to accept securities donations. Contributing appreciated assets to a DAF allows those assets to be sold so the money can be sent to charity with little or no hassle.
Create a legacy
A DAF allows ordinary people to grow their money over time, and give it to charity as a philanthropist would, like Bill and Melinda Gates, without having to go through the process of setting up their own foundation. Many DAFs, if not all, also give you the ability to name your fund. It’s common for investors to name their fund for its purpose – “The Smith Family Education Foundation,” for example. But, unlike a private foundation DAFs do not have to disclose to whom they make distributions, giving the donor more privacy.
DAFs also allow you to name your successors and share the management of your fund with your children when they turn 18. In time, your successors can also name their own successors – which can create an ongoing legacy for your family. Don’t want to name a successor? Not a problem. You can also specify how and to which charities your funds are distributed over time.
When you give to charities during the year, the DAF will track your contributions, as well as provide a single tax document, which can ease your record-keeping hassles. There’s no need to track down gift receipts or copies of checks, which makes filing your tax return much easier.
When not to use a DAF
While donor-advised funds offer a range of benefits for the right type of donor, they are not the best charitable giving option for everyone.
Smaller annual gifting amounts
If you want to donate smaller amounts in cash and you know exactly which charities you want to donate to, it may make more sense to donate directly rather than setting up a DAF. Minimum initial investments can vary depending on the institution, with some starting at $5,000, while others require as much as $25,000.
Beware the deductible income limits
The tax code imposes various limits on the deductible amount for certain charitable contributions, depending on the type of property and the organization. For donor-advised funds, the limit is 60% of adjusted gross income for cash and 30% for stock or real property. Any unused deductions above this limit can be carried forward for five years, although this may negate some of the tax savings had you been able to make the full deduction in a single year.
You may need the assets in the future
Any gifts to a DAF are irrevocable, meaning you can’t take them back. For those that are charitably inclined, but may still need income, there are other giving vehicles such as a charitable remainder trust or pooled income fund that might be a better option.
In terms of comprehensive financial planning, there are few strategies that provide the varied opportunities made possible by a donor advised fund. As a result, the donor advised fund is a remarkably useful tool to help carry out your charitable goals. Please reach out to us to discuss how it might fit into your overall financial plan and whether a DAF is right for you.