Using donor-advised funds is a more advanced tax strategy that has gotten more popular recently with the introduction of the Tax Cuts and Jobs Act (TCJA) in February 2020. The TCJA nearly doubled the amount of the standard deduction, which makes it less advantageous to itemize deductions such as charitable contributions. For people with a lot of charitable contributions, donor-advised funds are one option to still get a deduction for charitable contributions.
A donor-advised fund (DAF) is a registered 501(c)(3) charitable organization that accepts contributions and generally funds other charitable organizations. While the concept of a donor-advised fund has been around for nearly 100 years, they were typically only used by the ultra-wealthy. And while it is true that donor-advised funds are still not going to be useful for the vast majority of people, recent tax law changes have made their use more prevalent.
You can set up a donor-advised fund with most brokerages, including Fidelity, Vanguard, and Bank of America. You can donate cash, securities, or other types of assets to the DAF. The exact list of assets eligible for donation depends on the brokerage. After you have contributed, you can then make charitable contributions from the balance of your account.
One common reason that people set up donor-advised funds is to maximize their charitable tax deductions in a particular tax year. To show why this can be beneficial, I’ll use an example:
Our example family files their taxes married filing jointly and has regular charitable contributions of $20,000 per year. The standard deduction in 2020 for married filing jointly is $24,800. Because their amount of charitable deductions is less than the standard deduction, they may not see any tax benefit from their charitable contributions (depending on their amount of other itemized deductions). In 2021 they again plan to contribute $20,000 to charitable organizations and again are unlikely to see any tax benefit from doing so.
Now consider this same family now decides to set up a donor-advised fund in 2020. They have extra money sitting around in low-interest savings or checking account or in a taxable investment account. So they set up a donor-advised fund in 2020 and fund it with $40,000 in cash, stocks, or other assets. They are eligible to take the full $40,000 as an itemized deduction, even if they only use $20,000 to donate to the charity of their choice. Then in 2021, they can donate the remaining $20,000 to their preferred charity. They will not be able to deduct any charitable contributions in 2021 but can instead take the raised standard deduction amount.
Another reason you might want to set up a donor-advised fund is that you may be able to deduct the full value of stocks or other investments. Again, I’ll use an example to help illustrate the point.
Let’s say that you have shares that you purchased for $20,000 that are now worth $50,000. Many charities, especially smaller organizations, are not set up to accept donations of stocks or other investments. So if you want to donate that $50,000 to charity, you may have to liquidate your shares. This will mean that you will have to pay tax on the proceeds.
With a donor-advised fund, you can donate the shares to your fund and deduct the full fair market value of your shares. Then the fund can make the contribution to the charity of your choice.
Another benefit to setting up a donor-advised fund is the ability to donate a wide range of different classes of assets. As we mentioned earlier, many charities are not set up in such a way to be able to accept non-cash donations. While the exact list of assets that a donor-advised fund can accept varies by the firm running the fund, it generally will include more types of assets than a typical charity.
While there are plenty of advantages to setting up a donor-advised fund, there are a few things that you might want to watch out for.
It’s also important to keep in mind, the annual income tax deduction limits for gifts to donor-advised funds, are 60% of Adjusted Gross Income for contributions of cash, 30% of AGI for contributions of property that would qualify for capital gains tax treatment; 50% of AGI for blended contributions of cash and non-cash assets.