Donor-Advised Funds
Imagine that its November and your CPA has just prepared your tax projections for the year, and informs you that come April, you will be writing significant checks to the IRS and the state you live in.
Now imagine that he/she says there is something proactive you can do about that. A strategy that combines tax benefits + charitable giving, all while still allowing you some control over your investments. Insert the Donor-Advised Fund, or DAF for short.
A Donor-Advised Fund (DAF) is a strategic tool for charitable giving that offers significant tax benefits.
In a DAF, the donor makes contributions to the fund, receives an immediate tax deduction, and then directs how the funds will be distributed to various charities over time. The sponsoring organization (we prefer Charles Schwab Charitable) facilitates grant distributions based on the donor's recommendations.
DAFs offer several key benefits that can help reduce your tax burden, including immediate tax deduction, avoidance of capital gains taxes, and tax-free investment growth.
When you contribute to a DAF, you receive an immediate tax deduction for the full amount of your contribution in the year it is made. This deduction can significantly reduce your taxable income for that year. For cash donations, you can deduct up to 60% of your adjusted gross income (AGI), and for appreciated securities, up to 30% of your AGI (IRS Publication 526, 2022). However even with these limitations, any donations in excess can be carried forward for up to 5 tax years.
One of the most significant tax advantages of DAFs is the ability to donate appreciated assets, such as stocks or real estate, without paying capital gains taxes. If you sell appreciated assets, you must pay capital gains taxes on the increase in value. However, when you contribute these assets directly to a DAF, you avoid these taxes and can claim a charitable deduction for the full fair market value of the asset.
Contributions to a DAF can be invested to potentially grow over time. And, the growth within the fund is tax-free. This allows your contributions to increase in value and provides more funds available for charitable grants in the future.
DAFs can be extremely helpful in mitigating your tax bill, and there are several ways to leverage them to get the most out of your contribution.
Contributing to a DAF in a high-income year can maximize your tax deduction. For instance, if you experience a significant increase in income—such as from a bonus, stock sale, or other financial windfall—making a substantial contribution to your DAF can offset the higher income and reduce your tax liability for that year.
Instead of selling appreciated assets and donating the proceeds, contribute the assets directly to your DAF. By doing so, you avoid paying capital gains taxes on the appreciation. For example, if you own shares of stock that have appreciated significantly, donating the shares to a DAF allows you to avoid paying capital gains taxes while receiving a charitable deduction for the full market value of the stock.
If your income fluctuates from year to year, you can use a DAF to smooth out your charitable contributions. Make a large contribution to your DAF in a high-income year and then distribute the funds to charities over several years. This approach allows you to take a substantial tax deduction in the current year while supporting charitable causes over time.
Make a contribution to your DAF before the end of the tax year to ensure you receive the tax deduction for that year. This can be particularly useful for individuals who want to reduce their taxable income and lower their tax bill before the year ends.
Establishing a DAF and naming successors can also play a role in estate planning. By contributing to a DAF, you can create a charitable legacy while benefiting from current tax deductions. This can help reduce your estate tax liability and ensure that your philanthropic goals continue after your death.
While DAFs offer many tax benefits, there are a few considerations to keep in mind. DAFs often come with administrative fees charged by the sponsoring organization. These fees can vary and may impact the overall amount available for charitable grants. Another potential issue with DAFs can vary depending on the charity you choose. Donors may recommend grants to charities, but the actual distribution of funds can be delayed. While this provides flexibility in timing, it can also mean that funds may not reach charities as quickly as direct donations.
Donor-Advised Funds offer a powerful mechanism for reducing taxes while supporting charitable causes. Because of the ‘win-win’ nature of DAFs, their popularity has increased significantly. According to reports by the National Philanthropic Trust, contributions to DAFs have reached record levels in recent years. Their insights highlight the growing popularity of DAFs and their effectiveness in charitable giving (National Philanthropic Trust, 2023).
By taking advantage of immediate tax deductions, avoiding capital gains taxes, and benefiting from investment growth, donors can effectively manage their tax situation and maximize their philanthropic impact. As always, we recommend working with a tax professional who understands both tax strategies and wealth management.