Donor-advised funds are a powerful tool taxpayers can use to reduce their taxes. When handled properly, charitable contributions deductions can still be had, even if you do not itemize. If you itemise you can get a tax benefit that exceeds the donation to the charity all the while keeping your original investment.
A brief overview of the donor-advised fund (DAF) before we explore tax strategies.
You can set up a DAF at brokerage firms, such as Fidelity, Vanguard, E*trade, and more. You can contribute cash, stocks, or other assets to the DAF. Before opening a DAF be sure to review fees and policies.
Once a contribution is made the DAF has control over the asset. You retain and advisory role over the investments and which charity funds are disbursed to.
Cash
If you contribute cash to a DAF the additional tax benefit is limited. The tax deduction is realized when the funds are deposited at the DAF. Cash contributions work the same as contributing cash to any other charitable organization able to accept tax-deductible contributions.
However, you do have a timing play. You can fund a DAF with multiple years of your regular charitable contributions. The larger current contribution to the DAF may push you over the itemization limitations, allowing for an additional deduction.
Unlimited 0% Capital Gains Tax
Often people want to fund a DAF with appreciated assets because gains are not taxed to the donor while the full value of the contribution can be used on Schedule A.
Example: Let’s say you bought stock in Apple ($AAPL) many years ago for $50 per share. If Apple is now at $100 per share and you donate those shares to your DAF you get a double-dip tax benefit. You do not pay tax on the unrealized gains and you get a deduction for the full value of the Apple stock contributed to the DAF. If you were to sell the Apple shares first and then donate the cash to your favorite charity, you would pay capital gains tax on the profit. Better to donate to the DAF first.
Remember, you retain an advisory role in the DAF. You are not required to sell the Apple stock once contributed to the DAF. You decide when to sell, and what to hold inside the DAF. You also decide when to send the donation to your favorite charity. You can keep money in the DAF as long as you want, yet you get an immediate tax benefit.
This DAF strategy allows for timing of tax deductions and the avoiding of capital gains.
One thing to consider, if the investment goes up in value while inside the DAF, neither you, the DAF, or the charity receiving the funds upon distribution are taxed on those gains. If the assets inside a DAF decline, no additional deduction is available either.
Super-Charged DAF Strategy
Now we get serious about lowering our tax burden.
Even if you do not itemize or if charitable contributions lift your itemized expenses to a level where only some charitable contributions are deductible, there is still a way to get extra tax benefits.
Before we begin, let me point out that the DAF works best if you have appreciated assets and normally give to charity. You never contribute an asset to a DAF that has an unrealized loss! Doing do causes you to lose the deduction on that loss forever. With this in mind, we can now maximize the value of a DAF.
Let me list the tax benefits and then show how they work in action.
- No tax on capital gains.
- Tax deduction on contributions if you itemize.
- Here is the new benefit 99% of people forget, tax-gain harvesting without paying tax.
Let me explain.
Let’s use our Apple stock again. You bought the shares for $50 and they are now worth $100. Let’s also assume you contribute $10,000 each year to your church, but do not itemize so the deduction does not reduce your taxes. Let’s also assume you think Apple is still a good investment and do not want to reduce your holdings.
While many people overfund a DAF so they can itemize more in the current year than if the contributions to charity were spread over several years, I argue you should fund a DAF even when the funds will be distributed in mere days, weeks, or months. Here is why.
You can just open your wallet and give your church $10,000 over the course of the year. Or, you can move $10,000 worth of Apple shares into a DAF and then use the $10,000 of cash you planned on giving your church to buy replacement shares of Apple.
What happens when you do this? First, we acknowledge many people do not itemize due to the higher standard deduction since 2018. Unless you donate very large amounts, your charitable donations may mean nothing on your tax return.
But using our strategy outlined above, you pay no tax on the gain and the new shares have a basis of $100 versus the $50 basis of the old shares.
When you sell those Apple shares in the future your taxes will be lower for those new shares because the basis is higher. The only way you do not get a tax benefit is if you die before you sell the new Apple shares because your assets get a step-up in basis on date of death.
I argue that anyone with non-qualified investments (not inside a retirement account) with a gain should use this strategy for any charitable contributions. The example I just listed shows a possible break-even if you don’t itemize and never sell the new Apple shares. However, you can fund your DAF with enough investments to provide contributions to your church for years, allowing for a tax deductions that actually cuts your tax bill. And if you already itemize you get the full value of the strategy.
Many of my clients are serious about their charitable contributions. These same clients often have unrealized capital gains from investments. The strategy listed above maximizes the tax benefits from your charitable contributions.
One last thing, a DAF can have any asset contributed to it. That means cryptocurrencies, real estate, coins, and more. The only issue here in the DAF. Not every DAF accepts every type of asset. Always check before opening an account.
There you have it. A short blog post today. And if you put this one to work you instantly have multiple tax benefits. You get to do good things and get rewarded for the effort.
Be well.
