Strategic Ways to Use Donor Advised Funds
A donor advised fund can be used to support beloved charities and reduce an individual’s income tax liability. In order to employ them effectively, it is important to understand the structure, the income tax treatment, and the strategies that will provide the most bang for the buck.
Structure
There are three entities involved in a donor advised fund transaction: a donor, a donor advised fund sponsor, and a charity. A donor contributes money to the donor advised fund sponsor, which is classified as a charitable organization. The donor advised fund sponsor holds the proceeds in an account for the donor and provides investment options to the donor while the funds are held. When the donor decides to fund a charity, the donor directs the sponsor to transfer the proceeds from the account to an IRS qualified charity. The charity will then use these proceeds to fund the charity’s mission.
Income Tax Treatment
Contributions to a donor advised fund are irrevocable, so a donor will never be able to recoup the amounts donated. Additionally, as noted above, the sponsor is considered a charitable organization. Because of these two characteristics, the donor will recognize a charitable deduction in the year the proceeds are contributed to the donor advised fund. Any investment income within in the donor advised fund is tax-free, but investment losses are not deductible. When the fund proceeds are transferred from the donor advised fund to an IRS qualified charity, no charitable deduction will be recognized as the deduction was recognized when the initial contribution to the donor advised fund was made. This tax treatment allows a donor to recognize a deduction in one year, and donate to one or more charities in the years following.
Strategies
Donor advised funds can create a sizeable tax deduction in a year when an individual has a sizeable income realization event. Examples include an employer stock realization event, the sale of an individually owned or closely-held business, the sale of an investment property or any other type of one-off transaction that would generate a significant amount of taxable income. If this event pushes the taxpayer in or near the highest income tax bracket in any one year, the donation to the donor advised fund will provide the highest income tax savings. Needless to say, an income tax deduction used in a 37% tax bracket is more valuable than one used in a 22% tax bracket.
Donor advised funds can reduce the income tax liability generated by Roth IRA conversions. These days, few people need convincing of the benefits of having well-funded Roth IRA as retirement approaches. However, the tax implications of a Roth IRA conversion can be prohibitive. One way to reduce the income tax associated with Roth IRA conversions is to make a sizeable contribution to a donor advised fund in the year of a conversion. This will have a similar effect in reducing the taxable income associated with realization events discussed above. When combined with the Roth IRA conversion, it will have the added benefit of the tax-free growth and tax-free distributions of the amounts converted from a traditional retirement account to a Roth IRA.
A donor advised fund can be a tax efficient way to divest from a concentrated equity position of highly appreciated stock. A taxpayer may want to divest a portion of a highly appreciated stock position to reduce concentration risk and rebalance the portfolio. Unfortunately, if the position is held in a taxable brokerage account, selling the position may result in a significant income tax liability. An alternative to an out-right sale, is to donated the highly-appreciated shares to a donor advised fund. Doing so will have a three-fold benefit. First, it will provide the donor with a charitable deduction of the appreciated amount (there is a 30% AGI limitation, so consult with your CPA to determine if this strategy works for you.) Next, it will help rebalance the portfolio by reducing the outsized equity position. Finally, this transaction will not trigger any taxable capital gains. Talk about tax efficiency!
A donor advised fund can also provide tremendous legacy planning opportunities. First, contributions to donor advised funds are not included in a decedent’s estate. Secondly, distributions from a donor advised fund can be made to the charity anonymously. This is a benefit for both those that are truly humble, and those who do not wish to be added to a charity’s marketing list. Finally, a donor can choose to include other family members in the discussion about which charities will receive the donor advised fund proceeds. This will engage children and grandchildren in the gifting process, and help define the family’s ongoing commitment to philanthropic endeavors.
Summary
When used strategically, donor advised funds can provide an individual with a tremendous amount of flexibility. From tax mitigation to legacy planning, donor advised funds are an incredibly effective tool in the financial planning process.
About the author:
JP Geisbauer is a Certified Public Accountant and a Certified Financial Planner ®. He is the founder of Centerpoint Financial Management, LLC, a retirement planning, investment management, and tax planning firm located in Irvine, CA.
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Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes financial, investment, tax or legal advice. Before taking any action on any topic discussed in this article, please consult with your financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.