Lately, I’ve been having a lot of conversations about donor-advised funds (DAFs). DAFs are like mini private foundations, allowing an investor to take a charitable deduction upfront, invest the funds to grow tax-free, and distribute donations to charitable organizations in future years. When funded with appreciated securities instead of cash, an investor receives the double tax benefit of the charitable deduction and the avoidance of capital gains tax. For investors with consistent charitable intent, DAFs are a great way to maximize income tax deductions in high earning years.
Here are a few things to know about donor-advised funds
What is it?
A DAF is an investment account established at a public charity. The donor receives a tax deduction in the year that funds are contributed to the DAF, and grants are made to charities of the donor’s choice in future years. DAF contributions can be made with cash, publicly traded securities, private business interests, even cryptocurrency. Once inside the DAF, funds are invested for tax-free growth.
Many DAFs are community-based organizations that pool donations from local citizens and focus on areas of need specific to their surrounding area. There are also DAFs dedicated to specific charitable causes such as religion, human rights, women’s rights, LGBTQ rights, environmental concerns, and almost any other charitable intent that exists. A more flexible option is to open a DAF with a broker-dealer that has created a public charity for the sole purpose of administering DAFs. These DAFs allow donors to send grants to any approved 501(c)3 nonprofit institution, while community based DAFs and affinity DAFs have a preference for specific donees.
How the tax deduction works?
The Tax Cut and Jobs Act (TCJA) in 2017 significantly reduced the number of taxpayers who itemize deductions by doubling the standard dedcution. This means that charitable donations are no longer considered in calculating a tax bill. Instead, most taxpayers use the standard deduction ($24,800 for married filing joint / $12,400 for single filers). With a DAF, charitable donations for multiple years can be lumped together in one large donation. This allows the taxpayer to itemize deductions in years when they have more taxable income.
For example, assume that a couple donates $5,000 each year to their church. They have no mortgage, and they are limited to $10,000 for the SALT (state and local income tax) deduction. They have $15,000 in potential itemized deductions. Instead, they use the $24,800 standard deduction on their tax return. The same coupe also owns 1,000 shares of Apple, Inc (AAPL) that are worth $109,000 today. Their cost basis on the Apple shares is only $5,000, which means they have more than $100,000 in unrealized capital gains. Assuming a 20% capital gains tax rate, the couple would owe $21,800 in tax if they sold these Apple shares.
In 2020, the couple opens a donor-advised fund and contributes five years of church donations to the DAF. They use appreciated shares of Apple worth $25,000 to fund this charitable donation. They continue to make their annual donation to the church of $5,000, only now the money comes directly from their donor-advised fund. As a result of the DAF contributions, the couple will itemize deductions in 2020 with $35,000 deducted instead of the standard $24,800. Additionally, the couple avoids paying capital gains tax on the appreciation of the Apple stock used to make the donation.
In short, this couple is using appreciated stock to fund five years of planned charitable donations in advance in order to lump the charitable deductions on one tax return.
Limitations on Deductions
For investors with charitable intent, DAFs can be a great tool for tax planning in high income years. But there are a few limitations to consider. Cash donations to a DAF are deductible up to 50% of AGI (adjusted gross income). In other words, an investor cannot bring a tax bill down to zero with this strategy. Donations of appreciated stock are limited to 30% of AGI in a given year. However, unused charitable deductions may be carried over for the following five calendar years.
DAF versus Private Foundation
High net worth investors with charitable intentions may consider setting up a private foundation instead of a DAF. While private foundations offer more options, donations to a private foundation incur lower deductibility limits than DAFs. Cash donations to a private foundation are deductible up to 30% of AGI (versus 50% for DAFs), and donations of appreciated securities are limited to 20% of AGI. The ability to carry forward deductions for five years also applies to private foundation donations.
Private foundations allow for more control of future grants to charitable organizations. Technically, donations to a DAF are completed transfers to a public charity. While most DAFs will accept instructions from the donor for grant distributions, they reserve the right to direct the funds to the charity of the organization’s choice. If the owner of a DAF dies before all funds are distributed, usually the DAF takes control of the remaining funds to direct future contributions, although there are some custodians that allow successors to take over the account. With a private foundation, control of the assets after death is the primary benefit and is one of the main reasons that high net worth families establish private foundations.
Private foundations cost more to administer, and they are required to pay out a minimum of 5% per year through grants. Foundations are able to make grants or scholarships directly to individuals in need and can donate funds to non-charitable entities, as long as the funds will be used for a charitable purpose.
To DAF or not to DAF?
For high income earning investors with charitable intent, DAFs are a great way to lump charitable donations in targeted tax years. Donating appreciated securities provides a one-two punch of taking charitable deductions and avoiding capital gains tax. Remember that DAF donations should push itemized deductions above the standard deduction ($24,800 / $12,400) in order to make a positive impact on the tax return. There are limitations to the deductions in any one year (50% of AGI for cash / 30% of AGI for appreciated securities), but you can carry forward deductions for five years. The decision of where to establish a DAF depends on the donor’s desire to assist their local community, a specific charitable cause, or prefer broad discretion in ability to make future grants to charity.