Tax Avoidance Strategy for Individuals: Donor Advised FundsSubmitted by Reby Advisors | Certified Financial Planners | Danbury, CT on July 13th, 2018
By Patrick Doherty, CFP®
Earlier this year we wrote about how qualified charitable distributions (QCD) may reduce the adjusted gross income (AGI) on your tax return if you’re over 70 ½ years old and have required minimum distributions (RMD) from an IRA or 401(k) account.
A donor advised fund account is another planning tool that may be used to reduce your income taxes and help fulfill your philanthropic goals. Unlike the QCD, it has no age requirement. Nor do you need a retirement account to use it to your benefit.
This article covers how a donor advised fund works and who may benefit from opening one.
What Is a Donor Advised Fund?
It’s an investment account specifically for charitable giving. Contributions give donors an immediate tax benefit, and the investments within the account may grow without tax consequences. Securities or cash in the account may be distributed to qualified non-profit organizations over time, on your schedule, including as a legacy.
How a Donor Advised Fund May Reduce Your Income Taxes
A few weeks ago, a client approached me with a good problem to have: they were in a high tax bracket and owned a significant amount of a highly appreciated stock. If sold, the profits would be taxed as capital gains.
It’s better to make money and get taxed on profits than to lose money and write off the losses, but if you can avoid or minimize the taxes on those gains, that’s even better.
A donor advised fund allowed this client to do just that.
Each year, this couple donates up to $5,000 to a handful of charities.
The donor advised fund account that we opened through Schwab enabled the couple to prepay five years of donations.
Why would they do this?
Originally, their itemized deductions – including their $5,000 to charity – added up to $18,000, which was less than the $24,000 standard deduction available to married couples.
Instead of donating $5,000 to charity as they normally would, they transferred $25,000 of their highly appreciated stock to the donor advised fund, which increased their itemized deductions to $38,000.
This shaved $14,000 off their adjusted gross income (AGI), reducing their income taxes by more than $5,000.
Because the $25,000 of appreciated stock was now in a tax-advantaged donor-advised fund account, they would not have to pay capital gains taxes on the profits: savings of $3,000.
All in all, the strategy reduced their income taxes by $8,000.
Most important to the couple, the charity would still receive the donations they would have received anyway, on schedule, over the next five years.
Plus, the couple may invest that $25,000 within the donor advised fund and have it grow tax free, fulfilling their philanthropic goals even further.
Who Else May Benefit from Opening a Donor Advised Fund?
A donor advised fund tends to be most beneficial to households in the following situations:
- Already give generously and consistently to (a) qualified non-profit(s), and plan to continue
- Have enjoyed a high-income year and will pay taxes on that income at a high tax bracket
- Hold highly appreciated assets that will be taxed as capital gains when sold
- Plan to leave a legacy behind to a qualified non-profit; assets within the account may grow without tax consequences and are not subject to estate taxes
Are There Any Disadvantages to a Donor Advised Fund Account?
In the example above, the couple used this strategy to make the sum of their itemized deductions greater than the standard deduction. If this was not the case and the couple had already been itemizing, then pre-funding the account with money they planned on donating in the future may have reduced their deductions in future years.
Additional considerations include:
- a minimum irrevocable investment (with Schwab Charitable™, it’s $5,000)
- tax-deductible securities contributions are limited to 30% of adjustable gross income (AGI)
- tax-deductible securities cash contributions are limited to 50% of AGI
- investment options are typically broad but may not include all options within a standard account
I highly recommend enlisting the help of a tax professional or qualified advisor to determine if this strategy is right for you. Please do not hesitate to contact Reby Advisors for guidance on tax efficient investing or other personal finance matters.
You may also download a complimentary tax planning chapter from Bob Reby’s Wealth Redefined: Charting the Way to Personal and Financial Freedom. Click the banner below.