I was meeting with a client recently and after hearing about their concerns over taxes and learning that they give to nonprofits/charities regularly, I asked them this: Have you ever heard of a Donor Advised Fund?
They had not.
I told them about it and it blew their minds.
A Donor Advised Fund or DAF is like a small-private foundation that any individual can set up. It’s an account where you can deposit or transfer assets and then make donations over time. You open the account through a sponsoring organization, such as Schwab, Fidelity or Vanguard and then contribute assets to it.
Once funded you can then “grant” money to the different organizations you support.
The benefits of utilizing this strategy:
- Tax deduction in year of contribution
- Avoid capital gains taxes of appreciated assets if assets are contributed in-kind
- Grants don’t have to be made all at once but can be spread out over many years
- Grants can be given to different charities
- Opportunity for contributions to be invested and grow – allowing you to grant more money and have a greater impact
Tax deduction in the year of contribution
A DAF is a charity in itself, so the moment you contribute to it, you get a tax deduction in that tax year (if you itemize). You don’t get a tax deduction when you grant the money out – only when you first contribute.
Let’s say that Bob contributes $10,000 to a DAF in 2021. And then grants $10,000 in 2022 to his favorite charity. If Bob itemizes on his taxes, he would get a deduction for $10,000 in 2021 only.
But what if you don’t itemize?
Here’s one of the super powers of a DAF. Let’s say that you are getting ready to retire and since this will be your last year of working, you’ll most likely be in the highest tax bracket. You give annually to charities, but have never gotten a benefit on your tax return since you always took the standard deduction.
Single 2022: 12,950
Married filing jointly 2022: $25,900 + $1,400 if over 65
Let’s say that Bob files as single and gives $5,000 to charity each year, which for him isn’t enough to get him over the standard deduction threshold. Since this is his highest earning year, he’ll get the greatest benefit if he can shave off some income.
If Bob were to put $15,000 into a DAF at once, he would be able to claim the itemized deduction and get the donation deducted from his income (which he wasn’t able to do before). He can also grant $5,000 for each of the next 3 years. He doesn’t have to pay it all out at once. In effect, by pre-paying his giving, capturing the greatest tax benefit, without withholding any support from his charity. With his tax savings, he might be able to give more or use that money for something else enjoyable.
DAFs are beneficial for people in high income earning years. They can fund them when their earnings are high and make grants in years when income might be lower. The charity will think you’re a consistent giver.
People that plan better give more.
Avoid capital gains if assets given in-kind
If you’ve owned an investment for any length of time, it most likely has appreciated in value. The IRS will want a piece of the action when you sell an asset for a gain (The difference between what you bought it and sold it for). This pesky tax can be avoided all-together by utilizing a DAF.
You can gift assets (like stocks, ETFs, mutual funds) directly to a DAF as long as it is in-kind (meaning you don’t sell it). You get the tax deduction AND you don’t have to pay taxes on the gain!
If you wanted you could repurchase that asset at current market values and you’d have just avoided capital gains taxes.
My wife was given some Disney stock when she was little. It was so long ago that the paper trail of the purchase price is nowhere to be found. If she was to sell it, she’d pay a lot in capital gains taxes. But if we were going to give $1,000 to a charity anyway, then we could transfer a few shares of Disney to the DAF (worth $1,000) and then repurchase the Disney shares with the $1,000 in cash we had planned to give away anyway.
We just avoided paying the capital gains taxes by gifting the shares in-kind to the DAF and we still own the Disney shares at a much higher cost basis.
Grants don’t have to be made all at once but can be spread out over many years
Once you contribute to a DAF you can take your time to grant the money to charity. You don’t have to do it immediately. You could give money now and then wait 5 years and give it then. Or give some every year.
It should be noted that once assets are contributed to a DAF, it is irrevocable. You can’t contribute money and then change your mind and take it back. If giving is a regular part of your lifestyle, then DAFs fit great. If consistent giving isn’t your thing, then you’d be way better off not donating and paying the tax. Don’t use a DAF to just get a tax deduction. That’s like spending a dollar so you can receive 20 cents. Bad math!
Remember, the tax year that you contribute to a DAF can get deducted on your tax return if you itemize.
Grants can be given to different charities
Just because you’ve granted money to the same charity in the past, doesn’t mean you have to keep doing the same one in the future. You can give to as many different charities as you want! You can stop giving to some altogether and start giving to others. It’s completely within your control.
Opportunity for contributions to grow
Once the funds are in a Donor Advised Account, that account can be invested just like any other investment account. You can choose a long-term allocation of stocks and bonds and have those funds grow and compound over the years.
A $5,000 contribution that grows at 7% over 5 years will turn into over $7,000.
A $100,000 contribution that grows at 7% over 5 years will turn into over $141,000.
With a little math, you could plan for a future gift starting today.