By Harness WealthTaxes — June 15, 2020

Tax Benefits of a Donor-Advised Fund

A donor-advised fund is a great way to manage your charitable giving and save on taxes. You can take a tax deduction immediately when you provide the donation. Then, the donated funds can be invested and grow tax free. Think of it as creating a sort of personal "savings account" from which you can make donations to causes you care about for years to come.

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Over time, those who contribute to a donor-advised fund have the opportunity to recommend grants the fund should provide to charitable organizations. You are able to make donations to the fund whenever you choose and can donate any type of personal asset, such as real estate, cash, or stock. 

Source: Fidelity Investments. This is a hypothetical example for illustrative purposes only. The chart assumes that the donor is in the 37% federal income bracket with an adjusted gross income (AGI) of $500,000. Assumes all realized gains are subject to the maximum federal long-term capital gain tax rate of 20% and the Medicare surtax of 3.8%. 

If this is a year where you will have a large tax bill from short-term gains or income related to equity actions, you may particularly benefit from making a large one-time charitable contribution to a donor-advised fund.

Work with an financial adviser to make sure you make this strategic donation correctly, and identify any other financial and tax opportunities you may be missing.

Immediate Income Tax Deduction

When you make an irrevocable donation of personal assets, you are able to claim a deduction from your income taxes for the full amount of your donation in the tax year it was made. You can even claim a deduction for the full market value of assets including real estate and closely held stock in a C-corporation or in an S-corporation.

While there are some limitations that apply (for example, you can only claim an immediate deduction for cash valued at up to 60% of your adjusted gross income or a deduction for securities at up to 30% of your adjusted gross income), you can still significantly reduce your tax bill due to your gift.

Capital Gains Tax Savings

If you make a gift of illiquid assets that have appreciated in value, you generally will not have to pay any capital gains taxes. This includes a gift of securities or real estate that has gone up in value since the time of your purchase. However, you generally must have owned the securities for more than a year to donate them at their fair market value and avoid capital gains tax.

Donating appreciated stock rather than first liquidating and then donating the proceeds can both eliminate capital gains and reduce your marginal income tax rate.

Estate Tax Savings

Individuals with larger estates could be subject to estate tax on the federal level. Some states also charge estate taxes as well. These taxes normally must be made by the estate when assets transfer to beneficiaries other than spouses.

However, a donor-advised fund is not subject to estate taxes which can provide significant savings.

Investments Appreciate Tax Free

Any invested assets that you have contributed to a donor-advised fund will be able to appreciate without income tax consequences. The ability to invest donated funds allows you to make a far more valuable contribution to the causes you’d like to support.

Reduction of Alternative Minimum Tax

The Alternative Minimum Tax is a mandatory alternative to standard tax that applies to taxpayers with substantial deductions. It ensures that every taxpayer pays at least a minimum rate of income tax by applying an alternate method of calculating taxes. AMT tax rates are valued at either 26% or 28%.

For taxpayers who are subject to the Alternative Minimum Tax, making a contribution to a donor-advised fund can reduce the impact of AMT on your tax bill.

Reduction of the Tax Burden of Financial Windfalls

When you sell a business, receive an inheritance, experience strong stock market returns, or otherwise experience a financial windfall, this can have substantial tax consequences. When you make a charitable contribution to a donor-advised fund, you can reduce your tax liability and limit the financial burden that your windfall could cause. Donation a portion of your windfall or your other assets at the right time could allow you to pre-fund many years of giving to your favorite charities while significantly reducing your IRS bill for the year the windfall was received.

Flexibility in the Donation Amounts and Timing

Although private foundations require minimum annual payouts of at least 5%, donor-advised funds are not subject to this requirement. Donors can decide how much they wish to contribute to different causes over time and can act only when there’s a cause they wish to support.

IRS regulations do not impose a time limit on when donors must recommend a grant, although some DAF providers do require regular grants be made. However, the DAF can typically be passed on if all the money has not been spent during the original donor’s lifetime. While rules vary, the majority of sponsoring organizations offering donor-advised funds enable the donor to appoint a successor advisor for at least one or two generations. This provides more flexibility while ensuring funding is available when it’s needed. 

Is a Donor-Advised Fund Right for You?

As you can see, there are ample tax-advantages associated with contributions to donor-advised funds. You can personally benefit from tax savings and simultaneously support causes you’re passionate about with contributions that can be invested and grown so that they make even more of an impact. You also retain the flexibility of choosing when to issue grants from your fund so you can support multiple types of charitable endeavors and organizations over time. 

A donor-advised fund is not the right choice for everyone, though, and it is important to understand the rules and regulations associated with contributions so you can maximize the tax benefits of this type of charitable giving. For example, you typically have to contribute a minimum initial donation of $5,000. 

If you are considering making a financial contribution to a donor-advised fund, you may wish to talk with an experienced financial advisor first to confirm this option is right for you. They can provide guidance on the best way to make your contribution so you maximize both your tax savings as well as the value of the contribution you are making.

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