Money Matters: Using donor-advised funds to avoid paying capital gains taxes

Jeff Witz, CFP

There are many ways to donate to charity; however, some methods are more effective than others. Often, the easiest ways of donating are the least effective. Donating cash, entering a credit card number online, or writing a check, although simple, are not the most tax-efficient methods of giving. In these circumstances, you donate money you have already been taxed on, and paper trails are more difficult to keep organized. Using a donor-advised fund is one of the most effective and efficient ways to make long-term charitable gifts. It incorporates the tax benefits of donating appreciated assets with the control of deciding which organizations receive charitable grants and in what amounts.

Donor-advised funds are a fast-growing charitable giving vehicle in the US because they are one of the easiest and most tax-advantageous ways to give to charity. A donor-advised fund is like a charitable investment account to support charitable organizations you care about. When you contribute cash, stocks, or non–publicly traded assets such as real estate, private business interests, and private company stock to a donor-advised fund, you are generally eligible to take an immediate tax deduction for the total value of the asset. Once in the fund, those assets can be sold tax-free and reinvested into other investment options. The investments can continue to grow tax-free, and when ready to distribute, you can recommend grants to any public charity qualified by the Internal Revenue Service (IRS).

The benefits of these funds are best illustrated with an example. Let’s say you invested $20,000, which grew to be worth $100,000 over the subsequent years. Under normal circumstances, you would sell those investments and pay 15% to 20% long-term capital gains taxes on the $80,000 gain. At a 20% capital gains rate, that could be as much as $16,000. After paying taxes, you could donate the remaining $84,000 ($100,000-$16,000) to charity. The amount paid in capital gains taxes significantly reduces the amount available to donate to the charity and the amount you can take as a tax deduction.

With a donor-advised fund, you can transfer the entire $100,000 in appreciated securities into the fund. The fund can sell the assets without having to pay capital gains taxes. You receive $100,000 in tax deductions in the year the assets are moved to the fund. It is important to note that contributions to a donor-advised fund are irrevocable; you can never take them back out for personal use. The assets are then reinvested, and charitable grants can be distributed to qualified charitable organizations at your direction. You are not required to donate all the assets in the year they are transferred to the fund. There is no mandatory annual distribution like there is with foundations, although most donor-advised funds require you to make at least 1 grant every few years. Donor-advised funds can spread distributions over many years and be passed down to children and grandchildren. They are a great tool for teaching family and loved ones about the benefits of long-term charitable gifting.

Charitable tax deductions are still limited to IRS rules. Under the new tax law, individuals can take tax deductions up to 60% of their adjusted gross income (AGI) for cash contributions and up to 30% of their AGI for noncash assets (investments, property, business assets, etc). You can contribute more than those amounts into a donor-advised fund, but any excess charitable deductions over the 60%/30% limits must be carried forward to the following year. Overall, if you itemize your taxes, contributing appreciated assets to a donor-advised fund is an excellent way to increase your total itemized deductions in a tax-advantaged way.

With the new higher standard deduction, many individuals no longer receive a tax benefit when donating to charity. One technique some use to receive a tax deduction for their charitable giving is a bunching strategy. In this strategy, an individual may not make annual gifts to charities for 2 to 3 years, but in 1 year, they will gather all the amounts they would have given in those previous years and give them all at once. Doing so can help all their deductions that year exceed the standard deduction, and they can receive a larger tax benefit in this year when donations were bunched. Many are making these bunched donations directly to their donor-advised funds.

Many strategies are available if you wish to donate to charities; however, donor-advised funds remain one of the most efficient and effective ways to make a gift. They maximize the benefits to charitable organizations and the tax deduction for the individual who establishes the fund. Appreciated assets are the best assets to move into the fund from a tax perspective, but it can accept a wide range of types of assets.

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