“What else can I do to lower my taxes?” one of our wealth-management clients asked us recently. Managing her taxes was one of her top priorities, as they are for many investors.
Tax planning was part of her financial plan, so we’d converted some of her IRA to a Roth IRA, harvested losses in her accounts to offset taxable gains, and managed year-end distributions to help her avoid big taxable payouts.
We also helped her gift appreciated investments to her children and charitable organizations.
Charitable giving was particularly important to her. Every year, she made generous donations to worthy causes, and she’d donated even more during the pandemic to help people who were struggling to make ends meet.
But her donations hardly made a dent in her tax bill. The Tax Cuts and Jobs Act of 2017 (TCJA) nearly doubled the standard deduction, so it was less advantageous for her to itemize her charitable deductions now.
So we worked with her CPA to help her establish a donor-advised fund (DAF) that would enable her to make donations in a more tax-efficient way.
DAFs can be ideal for people like our client who make substantial donations to charity, and 2021 could be a great time to open a charitable account. Here’s what you need to know to get started:
What is a donor-advised fund?
A DAF is a registered 501(c)(3) charitable organization that accepts contributions of cash, stocks, or other assets, and makes grants to other charitable organizations. You can open them at most major brokers, including Schwab and Fidelity.
The money in a DAF can remain invested in stocks or funds like any other investment account. This means the value of your donation can fluctuate based on the investments. You could be donating more or less than you had anticipated at the time of transfer into the DAF.
Donations to a DAF are irrevocable. Once you have donated to it, you cannot reverse this donation back to you.
DAFs have become more popular in recent years. Fidelity found that the number of donor-advised funds at Fidelity Charitable, its sponsoring organization, nearly tripled from 2011 to 2020, according to its 2020 Giving Report.
What are the tax advantages of a DAF?
A DAF provides flexibility as well as tax advantages: “You can choose to pay out a donation to an approved charity right away or invest the money in the donor-advised fund account and let it grow tax-free until you want to pay it out; either way, you get an immediate tax deduction,” Morningstar explained.
Support charities of all sizes
A DAF can help you support smaller charities, which may not be set up to accept donations of stocks or other investments. Within a DAF, you don’t pay gains taxes when you liquidate your shares. You can donate your shares into a DAF, take the tax deduction, and then liquidate your shares and donate the cash to charities.
Tax-smart estate planning
You also might benefit from a DAF if charitable giving is part of your estate plan. You could contribute the amount you plan to leave to charity into a DAF: you’ll get a tax break now, and the charity will get their share when the time comes.
Maximize your deductions
Perhaps the biggest advantage is that a DAF can help you maximize your charitable tax deductions in a particular tax year versus splitting it over a few years (also known as a “bunching” approach).
Consider a married couple who files their taxes jointly and makes annual charitable contributions of $20,000. Their contribution is less than the standard deduction in 2020 for married filing jointly ($24,800), so they may not see any tax benefit from their charitable contributions.
Now if this couple set up a donor-advised fund and contributed two years worth of donations at once ($40,000 in cash, stocks, or other assets), they could take the full $40,000 as an itemized deduction in the first year, even if they only give $20,000 to charity that year.
In the following year, they could donate the remaining $20,000 to their preferred charity. While they will not be able to deduct any charitable contributions from their taxes in the second year, they can instead take the standard deduction amount.
Simplify your annual giving
Additionally, if you are donating to many organizations, a DAF can simplify the tax paperwork. “When you give to charities during the year, the DAF will track your contributions, as well as provide a single tax document, which can ease your record-keeping hassles,” Consumer Reports wrote.
How much can I contribute to a DAF?
There is no maximum dollar limit for how much you can contribute to a DAF. The optimal yearly number for a tax deduction can vary for each individual or couple based on their AGI and tax situation. A thoughtful approach, looking at your current tax year and future years, is most beneficial.
If you are contributing cash, you can deduct up to 60% of your Adjusted Gross Income (AGI) put into a DAF. However, this 60% of AGI cap has been suspended for 2021, meaning 100% of cash donations to DAF can be deducted against your AGI on your 2021 taxes.
If you donate stocks or other investable assets, your deduction is capped at 30% of AGI for 2021.
Schwab reported that 60% of 2020 contributions to Schwab Charitable DAFs were “non-cash assets,” such as shares of stocks and mutual funds.
Why is 2021 a good year for a DAF?
You can contribute more of your income to a DAF in 2021, since the AGI cap has been suspended this year.
The strong gains from stocks over the trailing 12 months are another reason why a DAF makes sense now: if you own investments that have large embedded gains, you could transfer those assets into a DAF now and then donate to charities on your own schedule.
Is a DAF right for me?
Since this can be a useful strategy for maximizing your tax deductions, we partner with our clients and their CPAs to determine how a client can benefit from it.
We consider which causes our clients like to support, how much they donate to charity annually, what assets to use for these donations, and how much of their estate they want to go to charities once they pass.
Talk to your investment advisor, Financial Planner, and CPA to see if using a donor-advised fund might be beneficial for you.
Curious about how a FundX investment advisor might help you manage your taxes? Click here to set up a time to talk.
Information and data provided here should not be considered to be investment, legal, or tax advice. Investment decisions should be made after careful consideration of your investment goals and overall financial situation. Talk to your accountant, investment advisor, and Financial Planner before using a donor-advised fund.