While taxes aren’t the main motivator for donors, clients want a financial advisor who can offer tax-smart giving strategies that also allow them to reach their philanthropic goals.
There are endless ways to make a charitable gift, but donor-advised funds are an increasingly popular giving vehicle because they’re easy to set up, they offer more flexibility than other giving methods, and they give donors the ability to fulfill meaningful charitable goals.
How charitable deductions work with a donor-advised fund
Donating to a donor-advised fund (DAF) is like donating to any charity directly. Here’s how the process works:
Step 1: Open a DAF account. This involves completing an application and making the initial contribution.
Step 2: Make a contribution. Donors can contribute a variety of assets to a DAF like cash, securities, or other property. The nice thing about a DAF is that donors receive an immediate tax deduction for the full value of the gift, but they can choose to wait to recommend a grant to a charity.
Step 3: Recommend grants to favorite charities. Once the DAF is established and the contribution has been made, donors get to do the fun part – recommend grants to their favorite qualifying charities. This is done on Ren’s Modern Giving Platform, which also allows donors to research charities and choose which organizations to support.
Step 4: Review and complete the grant. Once the donor recommends a grant, the DAF sponsoring charity reviews the grant request to make sure the organization is qualified by the IRS to receive charitable gifts. Once it’s approved, the sponsoring charity distributes the funds to the organization on the donor’s behalf.
Donations of cash are straightforward. Clients receive an immediate deduction for the amount of their contribution to the DAF. For example, a gift of $50,000 comes with a $50,000 deduction.
Donations of public securities, on the other hand, are determined based on the high and low of the day the donation is received by Ren.
It’s important to note that the value of the donation for tax purposes is based on the securities on the date of the donation, not the donor’s cost basis or any unrealized gains or losses. In layman’s terms, this means if the securities have been held by the client for at least a year and appreciated in value since the donor acquired them, the donor may receive a tax deduction for the full FMV of the securities at the of the donation, without paying capital gains taxes on the appreciation.
- Adjusted gross income (AGI) limitations are another key point. For cash contributions, donors can claim a deduction up to 60% of their AGI, but if it’s securities or any long-term asset it will be 30% of their AGI.
- If donors can’t claim all that deduction because of their AGI limitation, they can carry it forward to the next tax year. Donors have five forward tax years, six years total.
Five effective strategies to use with a DAF
1. Bunching Strategy
This strategy can work well for clients who make consistent annual gifts to charity but are unable to get the benefits of charitable deductions because their itemized deductions are less than the standard deduction.
This strategy is a tax planning technique that involves combining multiple years of charitable contributions into a single year in order to exceed the standard deduction and itemize deductions on their tax return. This strategy can be particularly effective in light of recent changes to the tax code that increased the standard deduction, making it more difficult for some taxpayers to receive a tax benefit for their charitable contributions.
If clients plan to make consistent charitable contributions, they may consider combining (bunching) several years’ worth of planned giving into a single DAF contribution. This may enable them to itemize their taxes and realize a larger deduction in the current tax year.
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. And DAFs allow clients to recommend grants be made over time to their favorite charities, so they are front loading their charitable giving while avoiding potential high tax liability.
Remember, the tax deduction is received in the year you contribute to the DAF and not when the money is granted from the DAF to the charity.
There are several scenarios to consider with the bunching strategy:
Scenario – A windfall of income: A client gives small amounts to different charities every year, they don’t always know the charities they will support for the year, and sometimes they vary.
This year they had a windfall of income, and their accountant recommended a sizeable charitable donation of $200,000 in order to offset some of that income. While the client would like to donate to charity, they are unsure which charities they want to support.
By donating to a DAF before the end of the year, the client can receive a current tax deduction, reduce their tax liability, and can request grants to charities over time when they are ready to distribute. Meanwhile, the original gift to the DAF will have time to grow tax-free.
Scenario – Surpassing the standard deduction: A client gives $10,000 to charity every year but doesn’t have enough to itemize and exceed the standard deduction, which in 2023 is $27,700 for married couples filing jointly.
By having the client combine (bunch) several years of donations into one single year, they may be able to now itemize their deductions and receive a larger tax deduction. The client is able to take five years of charitable donations and combines them into one, making it a $50,000 contribution to their DAF. They now have enough to itemize and get a $50,000 tax deduction.
Scenario – Pre-funding charitable deductions: These clients are high earners who give $25,000 to charity per year and will retire at the end of the year. While their AGI is $400,000, it will drop to $125,000 per year in retirement.
If the clients choose to bunch three years’ worth of donations into a single year by transferring appreciated assets in-kind from their investment account, they can receive the full $75,000 ($25,000 charitable donation x 3 years) itemized tax deduction in the year the donation was made. This is because it was under the AGI threshold of $120,000 ($400,000 x 30%) for non-cash charitable contributions. Also, by transferring appreciated assets to their DAF instead of selling them they avoid the capital gains tax.
2. Roth Conversion
Converting from a traditional IRA to a Roth IRA can create a tax liability on converted amounts. However, advisors can help clients fulfill their philanthropic goals while being able to offset some of that taxable income resulting from the conversion.
Scenario – Roth conversion: A client has a Roth conversion of $400,000, with a 35% tax rate, which results in owing the IRS $140,000. After talking with their financial advisor, they decide to make a DAF charitable contribution of $100,000.
The taxes paid to the IRS go down to $105,000 – a $35,000 tax savings. Additionally, $100,000 will grow over time in their DAF until they are ready to grant it out to their favorite charities.
3. Portfolio Rebalance
When rebalancing a client’s portfolio, advisors look for tactics to maximize their wealth by managing their cost basis along with their balance of asset allocation. When you have charitably inclined investors, it can make sense for them to gift shares of overweighted holdings with a low-cost basis in a taxable account directly into their DAF.
Scenario – Appreciated assets: A client purchased shares of a company 30 years ago for $10,000. Today those shares are worth $50,000. When their advisor looks at rebalancing their portfolio, they suggest donating the shares to a DAF in-kind.
By donating the stock to their DAF, they avoid long-term capital gains taxes as well as the Medicare surtax (3.8%) if it applies to them. Assuming 20% bracket for capital gains, that’s a $9,520 tax deduction. If the client would still like to own that stock, they’re able to repurchase it in their brokerage account for a higher cost basis.
4. Streamline Tax Reporting
Setting up a DAF for clients helps them streamline their charitable giving into one single account. They make all their donations into the fund; the assets have time to grow tax-free and then they grant out to their favorite charities on their own timeline.
Scenario – Varied giving: During a wealth planning conversation a financial advisor discovers that their client regularly gives to 5-10 different charities per year. They aren’t always the same charities, and the donation amounts vary from year to year.
Unfortunately, at the end of the year, they must track down every charity they gave to, how much they gave, and locate the receipt for each donation for their CPA.
There’s an easier way. Their advisor recommends they pre-fund their charitable giving with a DAF so they get one charitable tax receipt with all the information their CPA needs. The client is thrilled because they can still recommend grants to as many charities as they wish, and while the funds are in their DAF, they are growing tax-free.
This creates an efficient way for your client to do all their charitable giving in one place.
5. Complex Assets
Cash gifts are usually the first donation option that donors consider, but appreciated non-cash assets, such as real estate or private business interests, are a unique opportunity for many clients to avoid capital gain taxes and achieve a high-impact charitable gift.
DAFs can evaluate and process the liquidation of assets. Contributions of complex assets to a DAF allow firms to manage liquidated assets, which boosts the firm’s and financial advisor’s assets under management.
The fastest-growing type of contribution to a DAF is the selling of private business interests. Donating a percentage of an interest held more than one year can potentially help donors eliminate capital gains tax and claim an FMV charitable deduction for the tax year the gift is made.
Scenario – Selling private business interest: A client is planning to donate shares of ownership of a private company worth $2,000,000 with a cost basis of $500,000.
If the client sells the company outright and donates the proceeds, then they would have a capital gains liability of $357,000 ($1,500,000 multiplied by long-term capital gains tax of 23.8%), reducing the charitable deduction to $1,643,000 since some of the proceeds were used to pay taxes. Tax savings are then calculated by multiplying the client’s charitable deduction ($1,643,000) by an assumed federal income tax rate (37%). The results are $1,643,000 to charity, $357,000 in capital gains tax, and a tax savings of $607,910.
Alternatively, if the client donates the private company directly to a DAF they will avoid all capital gains taxes and receive the full FMV of the donation ($2,000,000). Tax savings are calculated by multiplying the client’s charitable deduction ($2,000,000) by an assumed federal tax rate (37%). This results in $2,000,000 to charity, eliminating capital gains tax, and a realize a tax savings of $740,000.
Advisors who start charitable conversations early in the year and bring the topic up often with clients ensure they have the time needed to consider things like timing and crucial deadlines, how to align philanthropic and financial goals, and strategies for the client to leave a philanthropic legacy.
Ultimately, an informed financial advisor with time on their side provides smarter and more efficient giving strategies.
While some advisors may feel unsure how to start the charitable conversation, there are talking points that make it easy to get started. Instead of focusing solely on technical aspects such as tax benefits, clients prefer their financial advisor ask about the more meaningful parts of giving to get the charitable discussion rolling with clients.
