I’ve had the privilege of working with individuals and couples who are incredibly generous in supporting organizations and causes they care about. However, many of them were lacking a cohesive plan to align their donations with a thoughtful tax strategy. One powerful tool for charitably-inclined families to be aware of is a Donor Advised Fund.
A Donor Advised Fund (DAF) is simply a tax-advantaged financial account dedicated to charity. A few reasons why I’m a fan of these accounts are:
- They are easy to set-up and very low-cost
- You can donate cash, stocks, ETFs, or crypto to fund your DAF
- You can disburse funds to charities over a multi-year period
- You can lower your tax liability with a deduction in the year you fund your DAF
- No hassle with tracking receipts from your donations come tax season
Beyond these benefits, with some thoughtful planning you can leverage a DAF to create significant tax savings. First off, it’s important to understand how charitable donations actually produce a tax benefit to you. Charitable donations are only beneficial to individuals or couples who “itemize” their deductions. This means the sum of your eligible deductions > than the Standard Deduction. Eligible deductions are reported on Schedule A of your tax return and include the following:
- Medical expenses in excess of 7.5% of your Adjusted Gross Income (AGI)
- State, Local, & Property Taxes – up to a maximum of $10k
- Mortgage Interest on your Primary Residence
- Charitable Donations
In 2024, the Standard Deduction is $14,600 (Single Filers) and $29,200 (Joint Filers). So if your eligible itemized deductions are less than the Standard Deduction, you would simply claim the Standard Deduction.
Now the magic of a DAF is that you are in control of funding this account in a year that will benefit you the most from a tax perspective.
Donor Advised Funds are most powerful during high income years when you are in a high tax bracket. This is because you receive a tax deduction in the year you fund a DAF. A tax deduction is simply a method to lower your taxable income.
Let’s explore an example of how one family leveraged a DAF to fulfill their charitable goals.
Austin is a sales executive and he had a strong commissions year, so his total income is $600,000, which puts he and his wife, Katie in the 35% Federal tax bracket. In this scenario, a $1,000 tax deduction lowers his tax liability by $350.
Taking it further, let’s assume his real estate taxes exceed $10,000 and his mortgage interest is $15,000 for 2024. Since these two sources total $25,000, Austin and Katie will take the Standard Deduction, unless they donate more than $4,200 to charity.
Austin and Katie typically make annual donations of $10,000. While they would itemize their deductions in 2024, in this scenario, they would not receive a tax benefit on the first $4,200 of donations. Like most people who donate to charity, the tax benefits are not the driving force behind why Austin & Katie choose to support their church and the organizations they value. However, if there is a way to satisfy their donations AND lower their taxes in a high-income year, now that’s a WIN, WIN!
Enter Donor Advised Fund into the conversation.
As mentioned above, you receive a tax deduction when the account is funded. However, you determine when and where to make charitable disbursements from the Donor Advised Fund. (There’s no additional tax benefits when you disburse charitable grants from your DAF).
So now that we know what a DAF is and why it could be attractive, let’s dive into how one could go about funding this account.
1. Gifting Appreciated Securities – 2024 has been a strong year in the stock market and as a by-product, many investors have large embedded gains on their stocks, ETFs, or crypto positions they purchased years ago at a low cost-basis. For any positions you’ve held longer than a year, you can contribute them directly from your investment account to a charitable organization. What are the benefits?
- You avoid paying taxes on the gains.
- You’re eligible to take an income tax deduction for the fair market value of your investment on the date you contribute.
- Since the receiving organization is a 501(c)3 non-profit organization, they don’t have to pay taxes on liquidating your gift. This means the full amount goes to supporting causes you care about.
2. “Bunching” Multiple Years of Contributions into One Tax Year – Most taxpayers claim the Standard Deduction on their tax returns. As I mentioned above, you only receive a tax benefit for your charitable contributions if you itemize your deductions. One neat benefit of DAFs is that you can “pre-fund” donations for future years in one tax year and disburse the donations to charities of your choice over multiple years. So “bunching” enables you to get over the hump of the Standard Deduction to realize the tax benefits of charitable donations.
3. Reinvest Funds within your DAF to Amplify your Impact – While it’s great you can pre-fund multiple years worth of donations into one tax year, you may not want all of this money just to be sitting in cash. Another benefit of DAFs is that you can reinvest the proceeds within the charitable fund until you’re ready to disburse the funds to charity. Since the charitable fund is held at a tax-exempt organization, you don’t pay any taxes on the growth of your DAF balance, so the full proceeds go toward causes you care about.
If you’ve experienced a higher than normal income year and find yourself facing a large tax bill, then a Donor Advised Fund is an attractive tool to help lower your tax exposure and achieve your charitable intentions. Before you consider donating any exercised Incentive Stock Options, be sure to chat through this strategy with a tax professional or your financial planner.