Charitable giving is something most people think about around the holidays, but a year-round approach to strategizing your donations can lead to more impactful results. Donating money the “usual” way — writing a check — is often an inefficient way to give that results in greater costs to you and less benefit to the organization you’re trying to help.
A common practice when bequeathing a large donation to a charity is to sell assets such as appreciated stock to raise the cash, then deliver the cash to the charity. Tax planners cringe at this method: Selling that stock results in capital gains taxes, which you must pay before giving money to the charity. If you wish to donate $1,000, you must sell more than $1,000 in stock to cover the tax bill. That can generate income and capital gains taxes which, depending on your income, can be substantial. It would be considerably more efficient to donate to the charity without having to pay up to 40% of your donation in taxes!
That’s not the end of inefficiencies for traditional donation practices: While donations are tax-deductible, how you donate impacts how tax-deductible they are. Itemized deductions are not one-to-one; rather, they sync to your tax rate. If you pay a 20% tax rate, an itemized deduction represents 20 cents for every dollar you earn. Donating $100 gets you only $20 in tax savings. There’s a more tax-efficient way: It’s called the donor-advised fund, or DAF.
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How a donor-advised fund works
A donor-advised fund is a vehicle you control that is earmarked for charitable giving. As the donor, you have control over both the amount and frequency of fund distributions from the DAF. Until donated, those funds can be invested and grown to increase the value of the DAF. Importantly, unlike regular charitable giving, donations to a DAF are eligible for a 100% tax deduction. If you transfer stock with a fair market value of $100 from your retirement account, you get a $100 deduction.
Plus, by donating that stock directly to the DAF, you avoid having to pay capital gains tax. Better yet, because the DAF is a charitable account, when it sells that stock, it, too, does not have to pay capital gains. This means donations of highly appreciated stock benefit both you and the charities the DAF donates to, since your initial investment in that stock led to a much larger donation that does not get eaten away by taxes.
A growing advantage
This advantage becomes more significant with every tax bracket; if your marginal tax rate is only 5%, that represents saving a nickel for every dollar of adjusted gross income, or AGI. However, if your marginal rate is 37%, you can realize a significant tax savings with this donation strategy.
A further advantage of a donor-advised fund is that, while DAF donations have an annual deduction cap of 30% of your AGI, the remainder can carry over. For example, if you make $100,000 this year and donate $40,000 to a DAF, you can deduct only $30,000 from your taxes this year. However, you can carry the difference and deduct the remaining $10,000 next year.
This boils down to a charitable giving tax strategy that can also have real benefits for you. If you have highly appreciated stock or are the recipient of a large windfall, you may be facing a considerable tax bill. Instead of taking that hit, it may be wise to consider how much you plan to donate over the next decade or so, then earmark those funds now in a donor-advised fund. You can significantly reduce your tax liability while still spreading those gifts out over the years to come.
As with most things in the personal finance realm, properly setting up and taking advantage of a donor-advised fund requires careful planning. It’s always a good idea to work with your financial adviser to determine the most efficient charitable giving strategy for you.
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