Using a Donor-Advised Fund to Maximize Tax Deductions by Brian Fritzsche, CFASubmitted by Moller Financial Services on February 25th, 2019
Using A Donor-Advised Fund To Maximize Tax Deductions by Brian Fritzsche, CFA
Tax Changes For Charitable Contributions
Among the myriad changes to the U.S. tax system implemented after the passing of the Tax Cuts and Jobs Act of 2017 were some major alterations of the itemized deduction framework. The standard deduction was increased from $12,700 to $24,000 for 2018 tax returns (married filing jointly) and the deduction for state and local taxes (SALT)—including property taxes—was capped at $10,000 per year. Combined with the elimination of several popular miscellaneous itemized deductions, many taxpayers who previously itemized a large amount of state income and local property taxes are now staring at a potentially higher tax bill from only being able to claim the standard deduction. However, one deduction that did not get reduced was the charitable giving limit. The maximum deduction for cash contributions increased from 50% of adjusted gross income (AGI) to 60% of AGI starting in 2018. These changes have made the donor-advised fund (DAF) an attractive option for charitably-inclined investors who are facing major changes to their tax status.
What Is A DAF?
A DAF is a tax-advantaged investment account held at any custodian that sponsors charitable giving accounts. Donors make an irrevocable contribution into the fund and then can advise the custodian when to disburse any gifts to the charities of their choosing. The tax benefit of this contribution is that the entire donation amount is deductible in the year it was made, even if the gifts are actually sent from the custodian to the charities over several future years. This can help taxpayers who no longer itemize by pushing their itemized deduction amount over the standard deduction in the year the DAF is funded, and then taking the higher standard deduction in future years as funds are disbursed from the DAF to the charities. In the meantime, the funds can be invested at the donor’s discretion and the growth within the account is not taxed.
This type of gifting strategy has grown greatly in popularity. According to the National Philanthropic Trust, donors contributed a record-high $29.23 billion to DAFs in 2017, increasing the total amount held in DAFs over $100 billion for the first time. The new tax changes will likely spur this number to an even higher amount when 2018 data is released.
A Specific Example
Let’s look at a hypothetical married couple earning $200,000 per year that was itemizing $20,000 in state income and real estate taxes, $10,000 a year in mortgage interest, and $3,000 per year in gifts to their favorite charity. Under the 2018 tax laws, their total itemized deductions would only be $23,000 ($10,000 maximum state and local taxes plus the usual $10,000 in interest and $3,000 in gifts). Since the standard deduction is now $24,000, they would simply claim that on their tax return and the tax benefit of the charitable giving is lost. This $9,000 loss of allowable deductions would cost the couple $2,520 in tax savings. The tax brackets were lowered to counteract this, but for a lot of people, the lost deductions outweigh the reduced tax rates.
If instead the couple was to donate three years’ worth of gifts to a DAF, their current-year itemized deductions would now be $29,000 ($10,000 taxes/$10,000 interest/$9,000 gifting). This would allow them to itemize on the current tax return, while taking advantage of the new standard deduction in the following two years as $3,000 per year is distributed from the DAF to the charity. The end result is an extra $5,000 in allowable deductions while still distributing the same $3,000 per year to the charity, worth roughly $1,400 to our sample taxpayers. This effect is multiplied proportionally as the amount of annual giving increases, as the charitable write-off is only limited by the 60% of AGI maximum (for cash gifts). If they were to gift appreciated securities instead of cash, the couple would reap the additional benefit of not paying capital gains tax on the appreciation while still getting a deduction for the full market value of the securities. Keep in mind that the gift of securities deduction is limited to 30% of AGI.
It is important to note some of the limitations of using a DAF. First, most account sponsors charge an administration fee for holding the assets and making the charitable disbursements as requested. This can be an annual flat fee or a small percentage of the assets held within the DAF. Second, if you are planning to make charitable gifts from your IRA (a qualified charitable distribution, or QCD) to avoid having to make a taxable required minimum distribution, that QCD must go directly to a charity and not into a DAF.
Multiple Benefits Of Giving
A donor-advised fund is a useful vehicle for making sure that you can receive maximum tax deductions in addition to the charitable gift you are granting. This is especially true with the new wave of tax law changes enacted for the 2018 tax year and beyond. While giving to charity is considered good for the soul, the DAF can also help it be good for your pockets. The financial planners at Moller Financial Services can give further advice on this strategy so contact us if you have any questions.