Do you have highly appreciated investments? Do you also give annually but don’t give enough to itemize your deductions on your tax return? If so, you may benefit from tax planning with a donor advised fund. Here’s how:
What is a Donor Advised Fund?
According to one of my favorite investing resource sites – Investopedia.com, a donor-advised fund is a private fund administered by a third party and created for the purpose of managing charitable donations on behalf of an organization, a family, or an individual. In other words, a donor advised fund or DAF is a fund you can donate cash or appreciated stock to and get a large deduction now, and choose where and when the funds are given later.
The key takeaways:
- You can donate appreciated investments and get a deduction for up to 30% of your adjusted gross income.
- You can lump a year’s worth of donations now and get a large itemized donation as long as you’re willing to give up the money.
Itemized Deduction
In 2018, the Tax Cuts and Jobs Act (TCJA) eliminated or restricted many of us from itemizing our deductions. The act goes through 2025 so that may change. But as it stands now, if you’re like most of my clients and do not have a mortgage, you don’t have an interest to deduct. Your SALT or State and Local Taxes are limited to $10,000. So unless you donate $15,901, you’re going to use the standard deduction. For most of my clients that donate $10,000 to $12,000 per year, they simply do not get any tax deduction for their donations to charity.
Lumping Donations
If you lump donations and donate $20,000 in one year and nothing in the next, you can itemize $30,000 worth of deductions in the year of the donations. But you still only get an additional $4,100 deduction above the $25,900 standard deduction in 2022 for your $20,000 donation. Enter donor advised funds.
Using a Donor Advised Fund
If you know you’re going to donate $10,000 each year to charity and you can afford to do it, donate 5 year’s worth of donations to a donor advised fund. You get a full $50,000 charitable deduction plus your SALT $10,000 deduction for a total of $60,000 itemized deduction in one year. Note that cash donations to a donor advised fund are limited to offsetting 60% of your adjusted gross income.
In addition, you can make donating to a donor advised fund even more attractive by giving appreciated investments. While they are limited to a 30% adjusted gross income deduction, you do not have to pay tax on the capital gain from the appreciated investment.
An Example
One of my favorite clients donates around $10,000 per year to the local animal shelter. They also had a rather large holding in a mutual fund that periodically had a large capital gain distribution at the end of the year. These $20,000 to $40,000 capital gain distributions at the end of the year made tax planning for Roth conversions difficult.
The prior year, we planned on doing a $52,000 Roth conversion to use the remaining portion of the 22% tax bracket only to find out that the $40,000 capital gain from said fund pushed most of the conversion into the 24% tax bracket. After a few years of this we decided to make a change. The question was how to capture the gain without incurring a HUGE tax bill, which I’d estimated to be $42,000.
The Solution
We decided to donate a portion of the appreciated fund to a donor advised fund and capture the gain on the rest of the fund.
After some number crunching we moved specific shares, the most appreciated, to the donor advised fund to the sum of $57,000. This allowed them to itemize and after $10,000 SALT get a $67,000 itemized deduction. We then proceeded to capture the gain on the remaining shares of the fund.
The Result
Instead of a capital gain and federal and state tax bill around $42,000, they owed $4,839. They removed the fund from their trust and can do more predictable tax planning/Roth conversions. They can donate $10,000 each year to the local animal shelter or any other qualified charity they wish. They get the HUGE $67,000 itemized deduction this year and can use the large standard deduction in the remaining 4 years it’ll take to spend down the donor advised fund.
Takeaway
If you donate annually but cannot take advantage of the itemized deduction, you might consider a donor advised fund. If you have highly appreciated stock or funds in taxable accounts like a joint investment account or trust, you can donate these funds to a donor advised fund and do some really cool tax planning. Of course, consult a fee-only Certified Financial Planner that offers tax planning to have them crunch the numbers.
