With the passage of the Tax Cuts and Jobs Act on December 22, 2017, donor-advised funds have suddenly become a far more important vehicle to help charitably-minded, tax-conscious individuals and families benefit from their charitable donations.
In prior years, you may have enjoyed a charitable tax deduction along with other itemized deductions, but under the new tax law, with a giant increase in the standard deduction, it will be much harder for most people to realize that same tax benefit. However, a donor-advised fund may be the tool you need to continue to maintain your charitable giving while also maximizing your tax savings.
What is a Donor-Advised Fund and How Does it Help Reduce Taxes?
A donor-advised fund is an easy, tax-efficient way to contribute to your favorite charities (while minimizing your taxes). Anyone can open a fund with an initial contribution of $5,000 or more, after which the fund can be professionally managed and invested for future growth. Once a donor-advised fund has been established, the donor can make contributions to charities out of the fund’s assets at any time.
Donor-advised funds have become more useful to many taxpayers under the Trump tax plan.
Under the new law, charitable contributions remain a tax-deductible expense, but it will be much more difficult to realize tax benefits from itemization. Starting in 2018, the standard deduction increases from $6,300 to $12,000 for single filers and from $12,700 to $24,000 for those who are married and filing jointly.
The law also limits state and local tax (SALT) deductions to $10,000, which includes property taxes. If you live in a high-cost, high-tax state, your property taxes and state income taxes may well exceed the $10,000 limit, which means you will not be able to fully deduct all of the SALT taxes you pay as you have in the past.
These changes will make it more efficient for many taxpayers to simply accept the standard deduction, which, in many cases, eliminates the tax benefits of itemized deductions from charitable donations.
However, a donor-advised fund may allow you to make contributions on your preferred schedule while also maximizing the tax benefit of your donations. By front-loading several years of charitable donations into a single tax year gift to your donor-advised fund, you can realize the tax benefits from itemized deductions while also maintaining the freedom to make charitable gifts over time as you see fit.
Let’s assume that you give roughly $5,000 per year to various charities. With a donor-advised fund, you might contribute $25,000 once every five years, thus maintaining the same rate of annual giving. Because a contribution to a donor-advised fund is immediately tax deductible, you would contribute enough to enjoy the tax benefit of a gift in year one, and then distribute $5,000 to charity annually (while taking the standard deduction) over the next five years.
Gifts of Appreciated Assets
In addition to the tax savings that can be generated from bunching your contributions and itemizing your charitable donations, you can realize further tax savings by donating appreciated financial assets to your donor-advised fund. If you have appreciated assets, this is perhaps the most tax-efficient way to contribute to a donor-advised fund, since you could realize a double tax benefit:
- You generate tax savings from the deduction of the donation.
- You avoid capital gains taxes on the appreciated assets.
Gifting appreciated assets can significantly reduce your tax liability and enhance the flexibility of your investment portfolio, making portfolio rebalancing less financially painful.
A Detailed Donor-Advised Fund Example
Let’s look at another hypothetical example of a married couple filing jointly who are in the highest income tax bracket. In 2018, let’s assume their itemized deductions are below the standard deduction before considering charitable gifts.
If the couple made $5,500 in contributions to their favorite charities, this would increase their itemized deductions from $18,500 to $24,000, which means that they would not generate any tax savings from itemizing deductions on their 2018 taxes.
However, if the couple instead pre-funded five years of $5,500 charitable gifts via a $27,500 contribution to their donor-advised fund, this would increase their itemized deductions from $18,500 to $46,000, allowing them to fully itemize for 2018.
In this example, they reduced their taxable income by an additional $22,000 above the standard deduction level. At the highest Federal income tax bracket, that represents $8,140 in tax savings.
Let’s also assume that the couple chose to make this $27,500 contribution to their donor-advised fund via appreciated assets with an unrealized gain of $27,000. The couple would save an additional $5,400 in taxes by donating an appreciated asset and avoiding the capital gains tax on the $27,000 capital gain.
Overall, the couple generated $13,540 in tax savings in 2018 using a donor-advised fund and bunching multiple years of contributions into a single donation.
The example above is oversimplified, and your own approach should be tailored to your particular tax situation. In reality, calculating their tax savings would be more complicated, as the couple would benefit from saving on other Federal taxes and potentially state taxes as well. Even if the couple had already been able to itemize, they might still have benefited from the bunching strategy by receiving their tax benefit right away rather than spreading it over several years.
Nevertheless, the example illustrates an important point: donor-advised funds are a useful tax planning and charitable giving vehicle, particularly for taxpayers who are in a high-income tax bracket and regularly give to charities. Under the new tax law, they have become even more useful. They provide the flexibility to make charitable contributions at your convenience while allowing you to bunch the tax deductions from those contributions into a single year.
If you think a donor-advised fund might be right for you, why haven’t you contacted your tax professional or financial advisor to discuss your options?
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