Analysis of Donor Advised Funds for Charitable Giving
Overview
Only certain types of investors and cases are best-served by Donor Advised Funds, such as those nearing retirement or hold a stock with an upcoming taxable event, such as an acquisition
Holding stock in a brokerage account “earmarked” for donations is more tax efficient and flexible for most donors than a donor-advised fund (DAF)
DAFs are limited to what the sponsor allows, such as relatively high-cost funds or total market indices, and cannot be used for tax-loss harvesting
Introduction to Donor Advised Funds and Charitable Giving
The highest earners know that a smart charity strategy is both socially responsible and an important part of tax planning. Charitable contributions of stock or cash can be deducted on personal itemized tax returns. However, when donating stock, the donor also bypasses long-term capital gains tax if itemizations total above the standard deduction.
Simply put, if you have a set of appreciated stock, then you can donate shares to 501(c)(3) charitable organizations completely tax-free. There are two ways to give stock: either directly to the charity or through a mechanism called a donor-advised fund, or DAF for short.
Donor-advised funds were made popular by the large brokerage firms to manage philanthropic giving. Brokerages open a charitable entity that has 501(c)3 status, and manages a brokerage account that aggregates all donated funds and assets. The brokerage house will sponsor the operators and charge fees for the investment product and ongoing maintenance of the platform.
These DAFs have been marketed as vehicles where you can set aside money in a fund, let it grow, and disburse it over time. Donors can fill their donor-advised fund with cash, appreciated stock, or other illiquid assets. The primary benefit of a DAF is that by using this segregated account, donors are able to take a deduction all at once, and then choose a later date where to contribute the funds. Over $4.3 billion of cash is donated each year to the top two DAFs alone. However, most DAFs have tremendous lock in. This means they offer a limited number of investment choices once your assets are moved in, which are usually tied to the sponsor.
Cocatalyst teamed up with a certified financial planner (CFP) to dissect the marketed benefits of DAFs against giving stock to charities. For most donors, directly donating stocks offers more flexibility and the similar benefits to DAFs.
In order to understand the differences, let’s use a hypothetical scenario and analyze it from various tax benefits. In Scenario A, the donor moves $100,000 in stock to a donor-advised fund. In Scenario B, the donor keeps their stock shares worth $100,000 residing in a taxable brokerage account.
Uses of a DAF for Philanthropic Giving to Charities
Pass through Donations
A common use case for a fund is to open an account and use it as a pass through non-profit for donations. If you use a donor advised fund for this purpose, the experience requires you to open an account, fill out additional paperwork for transferring your stock, and then later grant the cash to a specific charity. That adds many steps that can drag out your donation. You can simplify stock donation process to charities to 5 minutes or less using Cocatalyst.
Long term investment account for philanthropy with Donor Advised Funds
Another use case for donor advised funds is to transfer assets into the DAF, take the tax deduction immediately, and remain invested in the market using mutual funds available in the DAF. When the donor is ready to give the funds to charity, the sponsor will sell the asset
We’ll discuss the benefits and tradeoffs of using a donor advised fund for this purpose in this article.
Tax Implications when you Contribute to a DAF
Tax loss harvesting
Tax-loss harvesting refers to the practice of selling certain stocks at a loss, and immediately buying a similar asset. For example, say you originally purchased VTI at $180 and it’s now trading at $140. You could sell those shares at a loss and buy SCHB, an identical total stock market ETF. Then, you can deduct the loss from VTI on your tax return, and defer those taxes until you sell the SCHB at a gain. Some call this an “interest-free loan” from the IRS.
When you donate your shares to a DAF, you can no longer tax-loss harvest. However, if you do a tax-loss harvest in a taxable account, and donate the stock, you can multiply your tax efficiency.
In our Scenario A, you donate $100,000 in stock to a DAF. The fund that the DAF uses dips in value to $80,000, and then rises back to $100,000. The DAF then donates to the charity at that time and the charity will receive $100,000 worth of money in cash.
In Scenario B, we’ll replicate the same market conditions except in a normal brokerage account. If you tax-loss harvested when the stocks dipped to $80,000, you would be able to donate a total of $105,000 for the same out of pocket cost. That’s because when you sold the stock at $80,000 at a loss of $20,000, you saved $5,000 on your taxes. After the shares rose back up to the original value, you can donate the shares. The extra $5,000 in money came from the deduction claimed on taxes for the original loss.
Tax Deductions in a Low-Interest Rate World
When you donate appreciated assets to a charity, you receive the full market value as a deduction and the assets, now owned by a charity, are not taxed when sold. DAF firms have used this benefit as the main selling point to attract individuals to open an account. If you donate shares from a taxable account directly to a charity, you receive the same benefit.
In Scenario A, you donate $100,000 in money to a donor-advised fund. A year later it appreciates 25% to $125,000. The entire amount can be granted to the local YMCA. while you gave $125,000, your deduction is actually only $100,000. In Scenario B, when you keep the $100,000 of money in a taxable account and bought an index fund. When the fund appreciates to $125,000 and you give it to a charity, your contribution counts as $125,000.
Investment Choices in a DAF
Most DAFs give you a limited investment choice of selecting what percentage should go to either the total stock market index or low-risk bond funds. They won’t allow you to invest in industry sector ETFs, or shares of large companies like Apple or Microsoft.
In Scenario A, let’s say the DAF holds your assets fully in the total stock market index. From June 28, 2019 to January 1, 2020, your assets would have grown 2.88% with the stock market. In Scenario B, if you invested in the technology sector index QQQ, you would be up an additional 29%. This significant difference is a clear benefit that donors could have if they are able to drive their own investments.
CARES Act Enhances Value of Charity but not through a DAF
Back in 2017, the Trump administration passed the Tax Cuts and Jobs Act (TCJA) and raised the standard deduction across the board. The TCJA raised the standard deduction for individuals to $12,200 and $24,400 for couples. As a result, the number of people itemizing deductions dramatically decreased after 2017. One report from Giving USA found that charitable giving in 2018 fell by an entire percentage point.
Charitable giving fell because the new rules raised the standard deductions for most people and eliminated a large number of itemizations, thus disincentivizing charitable giving. The new rules also doubled the estate tax exemption, which further disincentivized donations from wealthy families.
In April 2020, the CARES Act was passed to provide financial support from the coronavirus pandemic. As part of the CARES Act, Congress added sizable tax relief options to incentivize charitable donations to all donors, regardless of whether they itemize or use the standard deduction. However, these new tax break rules do NOT apply to donor-advised funds. The benefit only can be used for funds donated directly to a charitable organization.
Donating in a Rising Tax Rate Environment to a DAF
One investment tax proposal floating around in recent years is to increase capital gains tax rates. Currently, capital gains taxes are at normal income brackets for short-term gains, while long-term capital gains rates are either 0%, 15%, or 20%, depending on your income bracket. With stimulus passed as a response to coronavirus, Joe Biden has suggested raising the investment capital gains tax rates for high earners.
In Scenario A, you will lock in the current tax savings rate from the one-time deduction resulting from creating the DAF. However, donating over time in Scenario B would be the best way to reduce your total tax exposure. If capital gains tax does increase, the amount you save by donating stock instead of selling it also increases.
Specialized Benefits of Donor Advised Funds
Certain types of investors may wish to use a DAF. In some portfolios, such as National Philanthropic Trust, rebalancing the index or funds might result in capital gains, which wouldn’t be taxable in any given year that the proceeds would not be disbursed to charities.
If the investor were at retirement age and projected income was about to drop significantly, a DAF may make sense to immediately avoid taxes for the amount to be funded.
If a particular stock is likely to go down in value, and the investor does not want to donate the entire amount of shares at the same time, a portion could be converted to fund the DAF.
Privately held assets such as real estate can also fund a DAF.
Conclusions
Donating stock to charity is a rapidly growing practice, as investors learn of the tax benefits. Stock donation has previously been considered the purview of the wealthy, but education and awareness for ordinary shareholders is growing. Donating stock is not only often more impactful for charities, but also helps the donor exceed the standard deduction thresholds and avoid capital gains tax on any profits generated from stock sales. If capital gains tax rates are raised in the future, this will become an even more attractive alternative to cash or credit cards. Donor-advised funds have limitations and minimums that can affect both donor and recipient.
If you are a donor interested in giving stock to any of the 1.4 million American tax-exempt charities, start the stock donation process today with Cocatalyst. The secure service is designed to streamline the giving process to 5 minutes or less. If you are a charity, Cocatalyst automates the tax receipts and liquidating process, enabling charities to accept donations easily from their website or email campaigns without red tape.