Do you have assets that are worth way more than you paid for them? These might be stocks, bonds, mutual funds, or even more obscure investments like privately held S-Corp shares or hedge fund interests.
Do you give to charity? These could be a number of charities such as your local church, school, hospital, or large organizations such as the American Red Cross—as long as they qualify as a 501(c)(3) organization under IRS standards.
If you said yes to either of these, a Donor Advised Fund, or DAF, could supercharge the donations you are already making. To understand how, we need to first understand how a charitable deduction is taken on your tax return.
When you file your tax return each year, there is a good chance that you get to deduct what is called the standard deduction. This is the deduction that is available to every taxpayer, regardless of income. This amount is $12,950 for single filers, and $25,900 for married couples filing jointly. But this is not the only deduction that is available. You might also get to deduct what are called itemized deductions. These are deductions that are taken on Schedule A of the tax return. There are numerous Schedule A itemized deductions, but the biggest three are the mortgage home interest deduction, the state tax deduction (limited to $10,000), and charitable deductions. The Tax Foundation estimates that only 13.7% of Americans itemize their deductions each year; and for good reason—the current standard deduction is huge.
See, you don’t get to take both your itemized deductions and the standard deduction, you only get the larger of the two. For the vast majority of Americans, they simply don’t have enough itemized deductions to exceed the current standard deduction. Let’s look at an example:
Bob and Mary have mortgage interest of $5,000 per year, they maxed out their property tax deduction at $10,000, and they gave $12,000 in cash to charity. They were good taxpayers. They kept track of all of their deductions over the year, and now they get to deduct $27,000 from their income. This was a great deal for them, right? Well, how much did they actually benefit from their itemized deductions? Their total contributions only exceed the standard deduction by $1,100 ($27,000-$25,900). In addition, they are in the 24% tax bracket, so their extra $1,100 deduction saved them a whopping $264 in taxes ($1,100 * 24%). It probably cost them way more than that just to have their accountant file their return!
So how can we improve their situation so that they actually benefit from their charitable bequests? A donor advised fund is the answer.
A donor advised fund will allow you to take a full deduction for the fair market value of the assets contributed (subject to certain limitations), invest them if you choose to, and then dole out the funds over a period of years however you so desire.
Let’s say Bob and Mary now donate $36,000 directly to a donor advised fund this year, instead of simply giving $12,000 directly to the charity. Now, along with their $5,000 mortgage interest deduction and their $10,000 property tax deduction, they are able to take total itemized deductions this year of $51,000 ($5,000+$10,000+$36,000). That means that instead of only getting an extra $1,100 of deductions, they now get an extra $25,100 tax deduction ($51,000-$25,900). That will save them a total of $6,024 in tax liability ($25,100 * 24%), a $5,760 improvement over the previous scenario ($6,024-$264).
But what about the next two years?
Simple, they take the standard deduction the following two years while continuing to donate the same $12,000 they did before, distributed to the same charity directly from their donor advised fund. Their charitable goals have been achieved, while saving an additional $5,232 over the three year period—a win-win situation.
But, we can actually make their situation even better. Let’s say Mary has some stock that she bought 20 years ago. The company has done extremely well. In fact, she purchased it 20 years ago for only $6,000 and it is worth $36,000 today. If she sold this stock and donated the proceeds to the donor advised fund she would have to pay 15% in capital gains tax on the growth. That would translate to $4,500 in tax liability ($30,000 gain * 15%).
Instead of selling the stock, she could just contribute it directly to the donor advised fund. This does three things:
- It avoids the $4,500 tax liability associated with the sale of the stock
- It will allow her to immediately sell the stock inside of the DAF and reinvest it in a more diversified portfolio, or simply leave it in cash.
- She will still get the full $36,000 deduction for the full fair market value of the stock!
These tax benefits cannot be overstated. Similar results could be achieved by establishing a charitable trust, but that would involve paying an attorney thousands of dollars to establish the trust. With a donor advised fund you can do the exact same thing, for minimal administration fees charged by the sponsoring organization. And if you don’t like the idea of managing the investments yourself, most donor advised fund sponsoring organizations will allow your investment advisor to manage the account for you.
If you have highly appreciated assets and you give to charity each year there is truly no reason that you should not explore using a donor advised fund. If you are interested in any of the strategies discussed in this article please reach out to our office and schedule a complimentary visit, (800) 303-9255.
John Zeidler, CFP®, CPA, MSA
July 12th, 2022