In my 26-year career every once in a while a new product, new service, or new technology comes along that can really be impressive and a game changer.
While donor-advised funds aren’t new, they certainly are one of these examples. Unfortunately, many people who could benefit most from these funds --- executives and other high-earners --- do not know they exist. Yet, they can be the perfect solution for the charitably inclined who also seek tax relief.
How donor-advised funds work
A donor-advised fund (DAF) offers an easy way for a donor to make significant charitable gifts over a long period of time. A DAF is similar to a private foundation but requires less money, time, legal assistance, and administration to establish and maintain. A donor opens an account with the DAF and makes an irrevocable contribution. This can be in cash or with appreciated holdings. In the latter example, by transferring the actual holdings, the donor avoids the capital gains that would have been absorbed had the client sold that position to generate cash.
Regardless of the type of contribution, they are generally tax deductible by the donor in the year the DAF is funded. The donor then has the flexibility to make grants from the DAF to the public charity of their choice at any time. But the key is the client gets the tax benefit when the contribution is made to the fund, not at the time the fund distributes to the charity. So, a client using a DAF can “front end load” the tax savings by making a larger deposit in the DAF.
Donor-advised funds within a financial plan
While a donor-advised fund is pretty simple by itself, its execution can illustrate its power and usefulness in planning. Here is an example:
I have a client who donates approximately $50,000 per year to a charity of his choosing. In addition, this client has a large balance of his retirement-related funds in an IRA. While he is in his early 60s now, at age 70 1/2 he will need to satisfy the required minimum distribution on the IRA. The problem is the required minimum distribution for this client is much larger than his lifestyle needs. Therefore, he will be paying taxes on a distribution of income that exceeds his needs and thus results in a larger tax obligation.
I brought to his attention the idea of establishing an annual Roth conversion where we would convert a portion of his high balance IRA to a Roth and do so in a way to keep the effective tax bracket as low as possible. I went on to explain that my strategy was more involved than a simple conversion. I shared that I wanted to tie in his charitable commitment using a donor-advised fund. I explained to this client how a donor-advised fund works and then spelled out how we could tie his charitable intentions with a DAF and coordinate the tax savings on the DAF contributions to offset some of the taxes due on the Roth conversion.
In effect, he can continue to support the charity of his choosing by making a larger contribution to the DAF and then use the tax savings to offset the income tax created when converting some of the IRA to the Roth. In the end, he has maintained his charitable focus, saved money on the tax due, and moved money from the IRA to a Roth.
This is an example of why financial planning is so exciting to me and impactful to our clients. Are you charitably inclined? Contact me at 206-447-1440 or by email at [email protected] if you would like to discuss your needs and if a donor-advised fund may be of value.