For those looking to use their wealth to support charitable causes, a donor-advised fund (DAF) can be an effective tool. Donor-advised funds may allow you to optimize the tax benefits of your gift, grow contributions tax-free and simplify your giving. In this post, we describe how donor-advised funds work and some of the potential tax benefits they can provide.
How a Donor-Advised Fund Works
A donor-advised fund is a giving account that you establish at a qualifying sponsor. Once you open your donor-advised fund, you make an irrevocable contribution and receive a tax deduction immediately. You can then recommend grants from the fund at time of your choosing.
The DAF can be funded with cash, stocks, and bonds along with non-publicly traded assets such as real estate, business interests and cryptocurrency. The assets within the fund can also be invested to grow them over time and increase the amount of future grants.
Once you have made the contribution, the qualifying sponsor has legal control of the fund. The sponsor can invest the funds based on the donor’s recommendation. Then the sponsor can distribute the funds to the donor’s selected charities when the donor directs the sponsor to do so. The qualifying sponsor charges a fee to cover the costs of administering the fund.
Key Benefits of Donor-Advised Funds
Reduce Taxes During High Income Years – A donor-advised fund allows you to control the timing of your contribution and subsequent grants. This can be very beneficial for tax purposes. For example, if the current year is going to be an above average income year due to a large bonus at work or selling a company, making a large charitable contribution this year may be advantageous from a tax perspective.
For example, let’s say you sold a business this year and your income will be much higher than it will be in the next four years. You also plan to donate $10,000 per year for the current year and the next four years. By using a donor-advised fund, you could contribute $50,000 to the fund this year and then grant $10,000 per year to charities. By contributing this year, you will potentially be able to deduct the whole $50,000 during year when you are paying high tax rates.
Increase Tax Benefit Through Stacking Contributions – Using a DAF, you are also able to stack your charitable contributions. There is potentially a tax benefit to stacking contributions, even if your income is expected to be steady. This is due to the standard deduction.
There are two different ways to take deductions on your federal tax return – itemize deductions or use the standard deduction. If your itemized deductions are greater than your standard deduction, you would use the itemized deductions to reduce your tax bill. For 2022, the standard deduction is $12,950 for singles and $25,900 for married couples (slightly higher for seniors).
Itemized deductions include how much you pay for state and local income taxes, real estate taxes, mortgage interest and charitable contributions among others. Let’s take our example above and assume that you a joint filer and have around $15,000 in itemized deductions each year other than your charitable contributions. If you made $10,000 in charitable contributions each year, your itemized deductions would total $25,000, leading you to take the standard deduction each year which is slightly higher. On the other hand, if you used a donor-advised fund, and contributed $50,000 in the first year, your itemized deductions would be $65,000 during that year, much higher than the standard deduction. In the next four years, you would still take the standard deduction. In this second scenario, your deductions over the five-year period would be $39,100 higher.
Simplify the Donation of Concentrated Positions – By directly donating an appreciated asset (that has been held over a year) you can avoid paying taxes on the unrealized gains, increasing your potential charitable impact. This appreciated asset could be publicly-traded shares in a company, a piece of real estate or even ownership in a private company. For the example of publicly-traded stock, you can directly contribute your appreciated stock to your donor-advised fund. Depending on how your DAF is set up, the shares may then be sold and then you can use the proceeds make grants to various charities. This is typically a simpler process than directly gifting the shares of stock to the charities.
Ability to Grow Assets – Once you have contributed to a donor advised fund, many sponsors will allow you to select the investment allocation. This could range from all cash to a more growth-oriented stock portfolio. This gives donors the choice to try to grow their assets and increase their charitable impact over time.
Convenience of Tracking Donations – A secondary benefit of using a DAF is that your contributions and grants are tracked in one place. This makes recordkeeping easier when it is tax reporting time and when you want to review your gifts.
Utilizing a donor advised fund may help save on taxes and grow the assets, potentially increasing the charitable impact you are able to make. Whether a donor-advised fund is right for you depends on your charitable goals and other parts of your financial picture. If you would like to talk with a financial planner about whether a donor-advised fund fits with your overall financial strategy, please schedule a call with us here.