A donor-advised fund can be a great way to supercharge your charitable giving while minimizing your income taxes. Learn what it is and how it works.
At its simplest, a donor-advised fund (or DAF) is a charity that acts as a middle-man between you and the ultimate charity you want to support. I’ll use a church as an example in this explanation. The DAF takes your contributions and then passes them on to the church at your direction. You take the charitable contribution income tax deduction when you contribute to the DAF.
Let’s say you want to make a $50,000 donation to your church. You have $50,000 worth of appreciated stock in a taxable brokerage account, with a cost basis of $10,000. So you have an unrealized capital gain of $40,000. If you sell the stock to fund the donation, you will have to pay capital gains tax. Assuming a 15% capital gains tax rate and a capital gain of $40,000, that means you have to pay $6,000 in taxes. This leaves you with only $44,000 to donate.
Here’s where the donor-advised fund comes in to save the day. If, instead of selling the stock, you donate the stock to the DAF, your donation will be valued at $50,000. You do not have to pay any capital gains tax because you didn’t sell the shares. And you will have a tax-deductible charitable contribution of $50,000. The DAF can then sell the share for $50,000 and give the proceeds to your church.
Here’s an important point. You must have held the securities you donate for at least one year. While I’ve used a stock as an example, other securities can be used as well: mutual funds, ETFs, bonds, etc.
Here are some other things to consider:
- Your donation does not have to be re-donated in the same year. For example, you could give $50,000 to the DAF and then have them release $10,000 per year for the next five years. You still take the full $50,000 tax deduction up front.
- Because of this, DAF contributions can be great when you have years with abnormally high income. If you have high income this year that bumps you into a higher tax bracket, and you expect lower income next year in a lower tax bracket, you could use the DAF to pre-fund two years’ worth of charitable giving. You tax the income tax deduction in the high-income year, which can lower your total tax bill over the two-year period.
- DAFs generally allow you to invest money that is in the account, so your donation can grow larger that what you put into it. Of course, those investments could also lose value, leaving you with less money to donate. Be careful.
- Donations to a DAF are irrevocable. Once you contribute to the DAF, the money is no longer yours and they can’t give it back to you.
Because all of this is driven by the income tax code, it can be confusing and complicated to understand. At Dominion Financial Advisors, we value simplicity and we strive to help simplify our clients’ financial lives. Because we understand the in’s and out’s of things like donor-advised funds, we can help reduce complexity for our clients. Schedule a complimentary consultation with us to see how we can work together to remove some complexity from your life.