Many people, who have achieved or are well on their way to achieving their wealth goals, turn to philanthropy, and most begin their gifting in well-intentioned but haphazard ways. Even though their gifting is intended to benefit others, without a strategy behind it, it may not have the expected outcome for either the charity or themselves. At the very least, their philanthropy can become somewhat burdensome to manage. That’s why an increasing number of financial advisors are recommending donor-advised funds as a smarter, more flexible and more tax-efficient way for donors to give more thoughtfully and strategically.
What exactly is a Donor-Advised Fund?
A donor-advised fund is an account established for as little as $5,000 with a custodian, typically through an independent financial advisor, that is much like any other investment account except that contributions made to the fund are irrevocable charitable contributions. In essence, it acts as a repository for all of your charitable contributions until you decide when and to whom you want to make a gift. In the meantime, your contributions accumulate in an investment account – smaller accounts will be managed in pooled investment account while larger accounts may be managed by an independent investment manager.
Donors are eligible for a tax deduction in the year contributions are made, yet the gifts can be spaced out over many years and earmarked for the non-profit of their choosing. Aside from the immediate tax benefits, donor-advised funds will do all of the tax reporting. Additionally, any growth inside the fund is not taxed and, when donors gift appreciated assets, such as stocks, they realize no capital gains, so more of the net proceeds are passed on to the non-profit.
Why Donor-Advised funds?
Donor-advised funds are especially suited for donors who want to make substantial donations to a few charities or those who want to make smaller donations to a large number of charities. With a donor-advised fund, your philanthropy can become more strategically focused allowing you to separate the emotional and tax-oriented aspects of granting requests from the need to gift wisely and stress-free. When you make a granting decision, everything from the due diligence of the grantee to the distribution of the grants to the record keeping is handled by the custodian.
Optimizing Your Charitable Giving and Tax Benefits
On the surface, donor-advised funds are an excellent option for anyone who wants to make their philanthropy and tax-reporting more manageable and cost-effective. However, many donors may not be taking full advantage of all the charitable giving strategies that can maximize their gifting while reducing their tax burden. Here are a few ways donors can achieve optimal results with donor-advised funds.
Donating Appreciated Securities
When you donate appreciated securities instead of cash, you have the opportunity to magnify both your gift and your tax savings. When appreciated stocks are granted, the charity receives an asset that can appreciate further, increasing the gift value to the charity. As the donor, you receive an immediate tax deduction for the fair market value of the gifted security. If you still like the security for your portfolio, you can repurchase it at a higher cost basis, which means you’ll owe less on future taxes if you ever sell it. The net effect is you still own a desirable stock, but you gifted away future capital gains taxes.
As an example, say you purchase a stock for $5,000 and, over time it appreciates to $10,000. If you sold the stock, you would be liable for a capital gains tax on $5,000. If instead, you donated the stock to a donor-advised fund, a charity would receive the full market value of the stock — $10,000 – and you would receive a current year tax deduction for the same amount. In essence, you leveraged a $5,000 investment into a $10,000 gift, which has the potential to appreciate even more. Yet, you also reap tax savings with the current deduction. If you repurchase the stock and eventually sell it, your tax consequence will be based on the higher cost basis. If you never sell it and pass it on to your heirs, you effectively defer the tax consequence throughout your lifetime.
You can make your charitable gifting more automatic by using the rebalancing of your portfolio as an opportunity to gift appreciated securities. Typically, with portfolio rebalancing, you trim off winning stocks and use the proceeds to purchase underperforming stocks, which can trigger a capital gains tax. By donating your winners to a donor-advised fund, you potentially avoid the tax, while managing the health of your portfolio.
Planning Liquidity Events
There are a number of gifting strategies available prior to a liquidity event that will not be available later. Entrepreneurs or stockholders who take the time to plan ahead are better positioned to take advantage of the leverage these strategies create to maximize both the charitable gift and the tax benefits. This is possible when you act before your assets increase significantly in value – in other words, before a sale or IPO.
For many business owners, the year they sell their business is typically the biggest tax year of their lives. By setting aside a portion of their business stock before selling it and donating it to a donor-advised fund, they can potentially fund their charitable giving for the rest of their lives while receiving the maximum tax deduction. The key is to do the necessary pre-liquidity planning to determine the optimum charitable contribution amount with consideration for tax implications along with current and future cash flow needs.
Estate and Legacy Planning
As an estate planning tool, the use of donor-advised funds offers the opportunity to remove contributed assets from your estate, so they aren’t subject to estate taxes. With the lifetime exclusion increased to $11.4 million in 2019 ($22.8 for married couples), families have a lot of flexibility to use a donor-advised fund in their planning. And, with the annual exclusion increased to $15,000, a husband and wife can contribute up to $30,000 per year without incurring gift taxes.
As a legacy planning tool, donor-advised funds offer families the opportunity to pass their philanthropic values onto future generations. A well-funded donor-advised fund will often survive its donors, giving heirs the opportunity to direct gifts during their lifetimes as well. Getting your children involved in the process teaches them the importance of the family’s legacy in effecting change and prepares them to take the helm in the future.
Some donors take it a step further and create a philanthropy policy statement that specifies the criteria for grants. This effectively removes any of the decisions for requests by family members or soliciting organizations.
In terms of charitable giving strategies, few offer the range of planning opportunities as donor-advised funds. Not many charitable giving vehicles offer the level of funding flexibility in terms of the types of assets that can be donated. Even fewer allow the opportunity to dictate how donors’ contributions are applied.
Overall, the donor-advised fund can provide the means for more strategic, deliberate and thoughtful charitable giving. However, it’s your beneficiaries that will reap the benefits. Through a structured gifting strategy utilizing a tax-favored investment fund, your contributions can go further and, through the potential growth of assets, your legacy can grow.