Last Updated on January 9, 2023
Have you ever wondered if there was a better way to give?
Do you get tired of tracking receipts, writing checks, and inputting credit card information on charity websites?
I know I did.
$100 here, $50 there, and by the end of the year, I’m trying to remember and track down the charities to which I donated.
A donor-advised fund can help.
A donor-advised fund is a way to simplify and potentially make your giving more tax-efficient. Plus, it could save you time and avoid the hassle of tracking receipts at tax time to claim tax deductions.
I’ll cover what a donor-advised fund is, what types of investments you can contribute to it, the tax benefits, how to decide how much to contribute to a donor-advised fund, and I’ll end with a hypothetical case study of how someone could use it.
What is a Donor-Advised Fund?
A donor-advised fund is like an investment account, but withdrawals can only be made to charities.
A donor-advised fund is an account with a public charity where you contribute cash, investments, or other assets. You can take an immediate tax deduction for those contributions, and the funds can be invested for tax-free growth. Then, you can recommend grants to IRS-qualified public charities.
Donor-advised funds are particularly appealing because you can contribute highly appreciated investments held longer than a year and avoid having to recognize the long-term capital gain on that investment.
By contributing the investment to the donor-advised fund, you avoid having to pay the capital gains tax and then when it is sold inside the fund, it is sheltered from taxation. I’ll explain more in the case study later.
Where Can You Open a Donor-Advised Fund?
There are many sponsoring organizations, such as Schwab Charitable, Fidelity Charitable, and Vanguard Charitable. Each of these are a 501(c)(3) public charity, which means contributions to the accounts are considered charitable donations.
What Can You Contribute to a Donor-Advised Fund?
You can contribute a wide variety of assets to a donor-advised fund. Ultimately, it’s up to the sponsoring organization to decide which assets they will accept, but it’s much more than cash and stocks.
Below are a list of possible assets you could contribute:
- Publicly traded securities (stocks, bonds, ETFs, mutual funds)
- Real estate
- Privately held business interests
- Fine art
- IPO stock
- Restricted stock
- Bitcoin and other cryptocurrencies
- Oil and gas royalty interests
While you can contribute cash, it’s usually one of the least tax-efficient ways to give.
If you have assets that have been held longer than a year and have appreciated in value, it’s normally better to contribute one of those assets because you may need to sell it one day, which would recognize the capital gain.
For example, if you have an asset worth $100 (doesn’t matter the asset – stock, real estate, business interest, etc.) that you bought for $10, you have a $90 capital gain.
At some point in the future, you may need to sell that asset to support your living expenses. Instead of giving cash and then selling that asset in the future, it would normally be better to donate the asset, avoid the $90 capital gain (assuming it is long-term), and use the cash for living expenses.
Tax Benefits of Using a Donor-Advised Fund
The tax benefits of using a donor-advised fund are similar to the tax benefits you would receive donating to any other charity.
You get an immediate tax deduction for the full market value for any long-term investments.
Long-Term vs. Short-Term
It’s crucial that any assets you donate are held for more than a year.
If you donate an asset held less than a year, it is considered short-term, and you can only deduct the cost basis (what you paid for it).
For example, continuing the example from above, if you donated an asset worth $100 that you paid $10 for, but you held it for 365 days or less, you can only deduct $10 – not $100. If you waited until you owned it for more than a year, then you can deduct the fair market value on the date of the donation.
Tax Deduction Limits
For those who are very charitably inclined or who have lower incomes, it’s important to be aware of the tax deduction limits.
If you are giving cash, you can only deduct up to 60% of your adjusted gross income (AGI).
If you are giving stock or real property, you can only deduct up to 30% of your AGI.
For example, if your AGI is $100,000, you can only deduct up to $60,000 worth of cash donations. If you are donating stock or real property, you can only deduct up to $30,000.
If you contribute more and are unable to deduct the full amount in the current year, you can carry over the unused amount to deduct for up to five years. If you haven’t used the full deduction in the five years, you lose the remaining amount. It does not carry forward.
Another benefit of using a donor-advised fund is using a “bunching” strategy.
Many people have a normal giving cadence. For example, they might contribute $5,000 per year to various charities. Unfortunately, with a higher standard deduction, they might not be able to itemize their tax deductions, and they likely wouldn’t feel comfortable giving five years’ worth of gifting, or $25,000, in a single year to potentially itemize their tax deductions.
But, with a donor-advised fund, they could give $25,000 to the donor-advised fund and then continue giving $5,000 per year to charities as they normally would.
The benefit of this strategy is that they can deduct the full $25,000 in the current tax year (assuming they are within the AGI limitations), and they can give the $5,000 as they normally would to various charities. I’ll go into more detail about this strategy in the next section and in the hypothetical case study at the end.
Deciding How Much to Contribute to a Donor-Advised Fund
One of the most common questions is, “How much should I contribute to a donor-advised fund?”
The answer is not simple. It depends on the tax situation and a person’s comfort level with gifting higher amounts.
Some people give a years’ worth of charitable gifts. I’ve seen others make a donation that may cover their own lifetime and multiple generations.
General Rule of Thumb – 5-10 Years of Charitable Giving
In general, I’ve found most people are not comfortable giving more than 5-10 years’ worth of charitable gifts in a single year. For example, if someone gives $5,000 per year, they may not want to give more than $25,000-$50,000 to a donor-advised fund in a single year.
However, there is nothing special about the 5-10 years worth of charitable giving. It’s okay to give more. I find most people can wrap their heads around that amount of gifting, and it’s not too far into the future to make it uncomfortable.
Don’t forget to take into account deduction limits and how much you can itemize on your tax return.
Analyzing Your Tax Situation to Decide
A better way to decide is to look at your own tax rate today and compare it to your estimated tax rate in the future.
For example, if you are in a particularly high tax bracket today because of a large Roth conversion, deferred compensation payout, or other income, you may be in the highest tax bracket you estimate you’ll ever be in.
Let’s say you are in the 37% tax bracket today and estimate in the future you’ll be in the 22% tax bracket. In this situation, it’s far more beneficial to take a tax deduction at 37% today than it is in the 22% tax bracket in the future.
If you contributed $50,000 to charity today and your marginal tax bracket is 37%, that is a tax savings of $18,500.
If you contributed $50,000 to charity in the future and your marginal tax bracket was 22%, that is only a tax savings of $11,000.
That’s a difference of $7,500 in tax savings!
It makes more sense to use a donor-advised fund when you are in a higher tax bracket. They can even be used by coordinating the bunching strategy with a Roth conversion to help reduce your taxes while shifting part of your portfolio to grow tax-free.
Hypothetical Case Study of Using a Donor-Advised Fund
Ann and Oliver give about $5,000 per year to 20 different charities. They enjoy giving to charity, but find tracking 20 different donations to be a big hassle.
Plus, they are giving cash, and they heard from their friend that they should look into giving highly appreciated investments. They started a brokerage account more than a decade ago and most positions have significant gains with the strong market growth of the past decade.
Their house is paid off, which means they don’t have any mortgage interest to deduct. They have about $10,000 worth of state and local taxes. Combined with charitable giving, they only have about $15,000 worth of itemized deductions, which is not larger than the standard deduction of $30,700 for two people over the age of 65 in 2023.
This means they are not receiving any tax benefit for their charitable giving.
While they give for the sake of giving and not for the tax benefit, they learn they may be able to use a donor-advised fund to get a tax deduction from their charitable giving.
Setting Up A Donor-Advised Fund
After learning more, they decide to set up and fund a donor-advised fund with 10 years’ worth of gifting, or $50,000.
Instead of selling investments with capital gains, paying the tax, and then contributing cash, they decide to fund the donor-advised fund with highly appreciated investments that have been held longer than a year.
Once they fund the account, the investments are sold and no capital gains taxes are due because the investments were sold inside the charitable account. Once sold, they selected the option to have the proceeds invested into a globally diversified portfolio.
They want to invest the funds because they have a 10 year timeframe and are comfortable taking some stock market risk to grow the funds, which will allow them to give more over time.
Going forward, they can login to their account and make a grant recommendation to the 20 charities they normally support. It’s as easy as a few clicks, and the sponsoring organization issues a check to the charity.
They don’t need to track receipts or how much they are giving.
Tax Benefits of the Donor-Advised Fund Contribution
Because they gave $50,000 worth of charitable contributions and have $10,000 worth of state and local taxes, their total itemized deductions are $60,000.
They now have enough itemized deductions to not claim the standard deduction.
Finally, they are receiving a tax benefit for their charitable giving.
Plus, they avoided the large capital gain. The original investments had a cost basis of $10,000, which means they would have had a $40,000 capital gain if they had sold them. They estimate they would have paid 18.3% on the capital gains (15% capital gains tax plus 3.8% surtax on net investment income), which means they would have paid $7,320 in capital gains taxes ($50,000 fair market value – $10,000 cost basis times 18.3% capital gains tax) had they sold the investments.
They are also proactively doing Roth conversions to the top of the 24% tax bracket because they estimate they will be in the 28% tax bracket in 2026 when tax rates revert to 2017 levels adjusted for inflation. The 2017 tax rates are higher than the current tax rates.
Since they have higher itemized deductions this year from the bunching of charitable contributions, they decide to do an even larger Roth conversion to fully use up the donor-advised fund contribution.
Their gross income for 2022 is around $400,000, and they are not paying more than 24%.
Normally, the extra Roth conversion would have bumped them into the 32% tax bracket, which meant they were saving taxes at a marginal rate of 32%. This means they saved an estimated $16,000 in taxes ($50,000 fair market value times 32% marginal tax bracket) from the donor-advised fund contribution.
Estimated Results from the Donor-Advised Fund Contribution
Ann and Oliver appreciated their new charitable giving strategy. They were able to:
- Itemize their tax deductions in the year they set up the donor-advised fund
- Do a larger Roth conversion than originally planned to shift more of their portfolio into growing tax-free
- Avoid capital gains taxes on the shares donated to the donor-advised fund
- Stop tracking 20 donations per year because they only had to track money going into the donor-advised fund – not when grants were made to charities from it
- Support the same charities as they had been supporting
- Invest the donor-advised fund, which allows them to give more to charity as their account grows
Donor-advised funds don’t make sense for everyone, but for people who normally give to charity and have appreciated investments, it is worth considering. For Ann and Oliver, they saved on taxes, simplified their giving, and were able to coordinate it with a Roth conversion tax strategy to likely reduce their future tax burden.
Final Thoughts – My Question for You
Donor-advised funds are an excellent tool to organize, simplify, and potentially make your charitable giving more tax-efficient.
Opening a donor-advised fund is normally a fairly easy process and can be opened with no minimums with some sponsoring organizations.
The administrative fees are reasonable (often 0.6% of the account value annually or $100, whichever is greater), and the donor-advised funds can accept a wide variety of investments.
With market growth over the past decade, many people have highly appreciated investments that would be excellent sources of giving instead of cash, checks, or credit cards.
As with any financial planning or tax strategy, it’s important to analyze your own situation, run mock tax projections, and determine if contributing a donor-advised fund would be beneficial in your situation.
They are also a great strategy to use in coordination with other tax planning strategies, such as Roth conversions.
I’ll leave you with one question to act on.
What step will you take to decide if a donor-advised fund is right for you?