In the financial services field, there is always a new product, strategy or software being touted as a “game-changer.” Very few provide enough value to stick around and change the face of planning. Donor-advised funds have beat those odds and have truly become a staple of financial planning. Even though donor-advised funds have increased in popularity over the last several years, many people who could benefit most from these funds do not know they exist. Yet, in many cases, they can provide the perfect solution to generate tax savings while also accomplishing philanthropic goals.
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 DAF is an account established through a sponsoring charity. The donor makes an irrevocable gift to an account owned by that sponsoring organization and can recommend charitable disbursements to charities of their choice thereafter. Because the sponsoring organization of a DAF is a charity, donors are eligible for an immediate upfront charitable deduction when they fund the account. Donors can grow their DAF assets and make gifts to their favorite organizations over time. Assets also grow tax free.
To ensure that gifts to the DAF sponsoring organization are completed for the purposes of the charitable deduction, the DAF sponsoring organization is not required to honor grant requests but, in almost every case, will—provided it can verify the public charity status of the organization.
Donations to the DAF can be in cash, with appreciated investment assets or with specialty assets, like real estate, collectibles or closely held business interests. Generally, if the donor gives appreciated assets to the DAF, the donor avoids the capital gains that would have been absorbed had the client sold that asset to generate cash.
Because the donor is eligible for a charitable contribution deduction when the DAF account is funded, a donor who would otherwise take the standard deduction can “bunch” several years’ worth of annual gifts into a DAF to feel the benefit of the charitable contribution and can then do their annual charitable giving from the DAF itself.
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 charities 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 72 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 proposed 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 fulfill his charitable intentions by contributing to a DAF and the tax savings from the DAF contributions would offset some of the taxes due on the Roth conversion.
In the end, he has maintained his charitable focus, is able to continue making his annual charitable gifts out of the DAF, saved on his taxes 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.