What Is A Donor Advised Fund and How Do They Work for Charitable Contributions?
Due to changes in the tax laws, fewer individuals are now able to capture a tax deduction for their charitable contributions. In an effort to recapture the tax deduction, more individuals are setting up Donor Advised Funds at Fidelity and Vanguard to take full advantage of the tax deduction associated with giving to a charity, church, college, or other not-for-profit organizations.
Due to changes in the tax laws, fewer individuals are now able to capture a tax deduction for their charitable contributions. In an effort to recapture the tax deduction, more individuals are setting up Donor Advised Funds at Fidelity and Vanguard to take full advantage of the tax deduction associated with giving to charity, church, college, or other not-for-profit organizations.
In this article, we will review:
The reason why most taxpayers can no longer deduct charitable contributions
What is a Donor Advised Fund?
How do Donor Advised Funds operate?
Gifting appreciated securities to Donor Advised Funds
How are Donor Advised Funds invested?
How to set up a self-directed Donor Advised Fund
The Problem: No Tax Deductions For Charitable Contributions
When the Tax Cut and Jobs Act was passed in 2017, it greatly limited the number of taxpayers that were able to claim a tax deduction for their charitable contributions. Primarily because in order to claim a tax deduction for charitable contributions, you have to itemize when you file your taxes because charitable contributions are an itemized deduction.
When you file your taxes, you have to choose whether to elect the standard deduction or to itemize. The Tax Cut & Jobs Act greatly increased the amount of the standard deduction, while at the same time it capped two of the largest itemized tax deductions for taxpayers - which is state income tax paid and property taxes. SALT (state and local taxes) are now capped at $10,000 per year if you itemize.
In 2024, the standard deduction for single filers is $14,600 and $29,200 for married filing joint, which means if you are a married filer, and you want to deduct your charitable contributions, assuming you reach the SALT cap at $10,000 for state income and property taxes, you would need another $19,200 in tax deductions before your reached that amount of the standard deduction. That’s a big number to hurdle for most taxpayers.
Example: Joe and Sarah file a joint tax return. They pay state income tax of $8,000 and property taxes of $6,000. They donate $5,000 to their church and a variety of charities throughout the year. They can elect to take the standard deduction of $29,200, or they could itemize. However, if they itemize while their state income tax and property taxes total $14,000, they are capped at $10,000 and the only other tax deduction that they could itemize is their $5,000 to church and charity which brings them to a total of $15,000. Since the standard deduction is $14,000 higher than if they itemized, they would forgo being able to deduct those charitable contributions, and just elect that standard deduction.
How many taxpayers fall into the standard deduction category? According to the Tax Policy Center, in 2020, about 90% of taxpayers claimed the standard deduction. Prior to the passing of the Tax Cut and Jobs Act, only about 70% of taxpayers claimed the standard deduction meaning that more taxpayers were able to itemize and capture the tax deduction for their charitable contributions.
What Is A Donor Advised Fund
For individuals that typically take the standard deduction, but would like to regain the tax deduction for their charitable contributions, establishing a Donor Advised Fund may be a solution.
A Donor Advised Fund looks a lot like a self-directed investment account. You can make contributions to your donor advisor fund, you can request distributions to be made to your charities of choice, and you can direct the investments within your account. But the account is maintained and operated by a not-for-profit organization, a 501(c)(3), that serves as the “sponsoring organization”. Two of the most recognized providers within the Donor Advised Fund space are Fidelity and Vanguard.
Both Fidelity and Vanguard have their own Donor Advised Fund program. These large investment providers have established a not-for-profit arm for the sole purpose of allowing investors to establish, operate, and invest their Donor Advised Account for their charitable giving.
Why Do People Contribute To A Donor Advised Fund?
We just answered the “What” question, now we will address the “Why” question. Why do people contribute to these special investment accounts at Fidelity and Vanguard and what is it about these accounts that allow taxpayers to capture the tax deduction for their charitable giving that was previously lost?
The short answer - it allows taxpayers that give to charity each year, to make a large lump sum contribution to an investment account designated for their charitable giving. That then allows them to itemize when they file their taxes and capture the deduction for their charitable contributions in future years.
Here’s How It Works
As an example, Tim and Linda typically give $5,000 per year to their church and charities throughout the year. Since they don’t have any other meaningful tax deductions outside of their property taxes and state income taxes that are capped at $10,000, they take the $29,200 standard deduction when they file their taxes, and do not receive any additional tax deductions for their $5,000 in charitable contributions, because they did not itemize.
Instead, Tim and Linda establish a Donor Advised Fund at Fidelity, and fund it with a one-time $50,000 contribution. Since they made that contribution to a Donor Advised Fund which qualifies as an IRS approved charitable organization, the year that they made the $50,000 contribution, they will elect to itemize when they file their taxes and they’ll be able to capture the full $50,000 tax deduction, since that amount is well over the $29,200 standard deductions.
But the $50,000 that was contributed to their Donor Advised Fund does not have to be distributed to charities all in that year. Each Donor Advised Program has different minimum annual charitable distribution requirements, but at the Fidelity program it’s just $50 per year. In other words, taxpayers that make these contributions to the Donor Advised Fund can capture the full tax benefit in the year they make the contributions, but that account can then be used to fund charitable contribution for many years into the future, they just have to distribute at least $50 per year to charity.
It gets better, Tim and Linda then get to choose how they want to invest their Donor Advised Fund, and they select a 60% stock / 40% bond portfolio. So not only are they able to give from the $50,000 that they contributed, but all of the investment returns continue to accumulate in that account that Tim and Linda will never pay tax on, that they can then use for additional charitable giving in the future.
How Do Donor Advised Funds Operate?
The example that I just walked you through laid the groundwork for how these Donor Advised Fund to operate, but I want to dive a little bit deeper into some features that are important with these types of accounts.
Funding Minimums
All Donor Advised Funds operate differently depending on the provider. One example is the minimum funding requirement to open a Donor Advised Fund. The Fidelity program does not have an investment minimum, so they can be opened with any amount. However, the Vanguard program currently has a $20,000 investment minimum.
Fees Charged By Donor Advised Sponsor
Both Vanguard and Fidelity assess an annual “administration fee” against the assets held within their Donor Advised Fund program. This is how the platform is compensated for maintaining the not-for-profit entity, processing contributions and distributions, investment services, issuing statements, trade confirmations, and other administrative responsibilities. At the time that I’m writing this article, both the Fidelity and Vanguard program charge an administrative fee of approximately 0.60% per year.
How Charitable Distributions Are Made From Donor Advised Funds
Once the Donor Advised Account is funded, owners are able to either login online to their account and request money to be sent directly to their charity of choice, or they can call the sponsor of the program and provide payment instructions over the phone.
For example, if you wanted to send $1,000 to the Red Cross, you would log in to your Donor Advised account and request that $1,000 be sent directly from your Donor Advised account to the charity. You never come into contact with the funds. The charitable distributions are made directly from your account to the charity.
When you login to their online portals, they have a long list of pre-approved not-for-profit organizations that have been already established on their platform, but you are able to give to charities that are not on that pre-approved list. A common example is a church or a local not-for-profit organization. You can still direct charitable contributions to those organizations, but you would need to provide the platform with the information that they need to issue the payment to the not-for-profit organization not on their pre-approved list.
Annual Grant Requirement
As I mentioned earlier, different donor advised programs have different requirements as to how much you are required to disperse from your account each year and some platforms only require a disbursement every couple of years. For example, the Vanguard program only requires that a $500 charitable distribution be made once every three years, but they do not require an annual distribution to be made.
Irrevocable Contributions
It’s important to understand that contributions made to Donor Advised Funds are irrevocable, meaning they cannot be reversed. Once the money is in your Donor Advised Account, you cannot ask for that money back. The platform just gives you “control” over the investment allocation, and how and to who the funds are disbursed to for your charitable giving.
What Happens To The Balance In The Donor Advised Fund After The Owner Passes Away?
Since some of our clients have substantial balances in these Donor Advised Funds, we had to ask the question, “What happens to the remaining balance in the account after the owner of the account passes away?”. Again, the answer can vary from platform to platform, but most platforms offer a few options.
Option 1: The owner of the account can designate any number of charities as final beneficiaries of the account balance after they pass away, and then the full account balance is distributed to those charities after they pass.
Option 2: The owner can name one or more successor owners for the account that will take over control of the account and the charitable giving after the original owner passes away. As planners, we then asked the additional question, “What if they have multiple children, and each child has different charitable preferences?”. The response from Vanguard was that the Donor Advisor Fund can be split into separate Donor Advised accounts controlled by each child, Then, each child can dictate how the funds in their account are distributed to charity.
Gifting Cash or Appreciated Securities
There are two main funding options when making contributions to a Donor Advised Fund. You can make a cash contribution or you can fund it by transferring securities from a brokerage account. Funding with cash is easy and straightforward. When you establish your Donor Advised Fund, you can set up bank instructions to attach your checking account to their Donor Advised Fund for purposes of making contributions to the account. There are limits on the tax deductions for cash contributions in a given year. For cash contributions, donors can receive a tax deduction up to 60% of their AGI for the year.
Funding the donor advised fund with appreciated securities from your taxable brokerage account has additional tax benefits. First, you receive the tax deduction for making the charitable contribution just like it was made in cash, but, if you transfer a stock or security directly from your taxable brokerage account to the Donor Advised Fund, the owner of the brokerage account avoids having to pay tax on the unrealized capital gains built up in that security.
For example, Sue bought $10,000 of Apple stock 10 years ago and it’s now worth $50,000. If she sells the stock, she will have to pay long term capital gains taxes on the $40,000 gain in that holding. If instead, she sets up a Donor Advised Fund and transfers the $50,000 in Apple stock directly from her brokerage account to her Donor Advised account at Fidelity, she may receive a tax deduction for the full $50,000 fair market value of the stock and avoids having to pay tax on the unrealized capital gain.
An important note regarding the deduction limits for gifting appreciated securities - the tax deduction it limited to 30% of the taxpayers AGI for the year. Example, if Sue has an AGI of $100,000 for 2024 and wants to fund her Donor Advised Fund with her appreciated stock, the most she can take a deduction for in 2024 is $30,000. ($100,000 AGI x 30% limit).
As you can see, transferring appreciated stock to a Donor Advised Fund can be beneficial, but cash offers a higher threshold for the tax deduction in a single year.
Donor Advised Funds Do Not Make Sense For Everyone
While establishing and funding a Donor Advised Fund may be a viable solution for many taxpayers, it’s definitely not for everyone. In short, your annual charitable contributions have to be large enough for this strategy to make sense.
First example, if you are contributing approximately $2,000 per year to charity, and you don’t intend on making bigger contributions to charities in the future, it may not make sense to contribute $40,000 to a Donor Advised Fund. Remember, the whole idea is you have to make a large enough one-time contribution to hurdle the standard deduction limit for itemizing to make sense. You also have to itemize to capture the tax deduction for your charitable contributions.
If you are a single filer, you don’t have any tax deductions, and you make a $5,000 contribution to a Donor Advised Fund - that is still below the $14,600 standard deduction amount. In this case, you are not realizing the tax benefit of making that contribution to the Donor Advised Fund. If instead, you made a $30,000 contribution as a single filer, now it may make sense.
Second example, not enough taxable income. For our clients that are retired, many of them are showing very little income (on purpose). If we have a client that is only showing $50,000 for their AGI, the tax deduction for their cash contributions would be limited to $30,000 (60% of AGI) and gift appreciated securities would be limited to $15,000 (30% of AGI). Unless they have other itemized deductions, that may not warrant making a contribution to a Donor Advised Fund because they are right there at the Standard Deduction amount. PLUS, they are already in a really low tax bracket, so they don’t really need the deduction.
This Strategy is Frequently Used When A Client Sells Their Business
Our clients commonly use this Donor Advised Fund strategy during abnormally large income years. The most common is when a client sells their business. They may realize a few million dollars in income from the sale of their business in a single year, and if they have some form of charitable intent either now or in the future, they may be able to fund a Donor Advised Fund with $100,000+ in cash or appreciated securities. This takes income off the table at potentially the highest tax brackets and they now have an account that is invested and growing that will fund their charitable gifts for the rest of their life.
How to Set-up A Donor Advised Fund
Setting up a Donor Advised Fund is very easy. Here are the links to the Fidelity and Vanguard Platforms for their Donor Advised Fund solutions:
Fidelity Donor Advised Fund Link: Fidelity Charitable Fund Link
Vanguard Donor Advised Fund Link: Vanguard Charitable Fund Link
Disclosure: We want to provide the links as a convenience to our readers, but it does not represent an endorsement of either platform. Investors should seek guidance from their financial professionals.
These Donor Advised Funds for the most part are self-directed platforms which allow you to select the appropriate investment allocation from their investment menu when you set up your account.
Contact Us With Questions if you have any questions on the Donor Advised Fund tax strategy, please feel free to reach out to us.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Lower Your Tax Bill By Directing Your Mandatory IRA Distributions To Charity
When you turn 70 1/2, you will have the option to process Qualified Charitable Distributions (QCD) which are distirbution from your pre-tax IRA directly to a chiartable organizaiton. Even though the SECURE Act in 2019 changed the RMD start age from 70 1/2 to age 72, your are still eligible to make these QCDs beginning the calendar year that you
When you turn 70 1/2, you will have the option to process Qualified Charitable Distributions (QCD) which are distribution from your pre-tax IRA directly to a chartable organization. Even though the SECURE Act in 2019 changed the RMD start age from 70 1/2 to age 72, your are still eligible to make these QCDs beginning the calendar year that you turn age 70 1/2. At age 72, you must begin taking required minimum distributions (RMD) from your pre-tax IRA’s and unless you are still working, your employer sponsored retirement plans as well. The IRS forces you to take these distributions whether you need them or not. Why is that? They want to begin collecting income taxes on your tax deferred retirement assets.
Some retirees find themselves in the fortunate situation of not needing this additional income so the RMD’s just create additional tax liability. If you are charitably inclined and would prefer to avoid the additional tax liability, you can make a charitable contribution directly from your IRA and avoid all or a portion of the tax liability generated by the required minimum distribution requirement.
It Does Not Work For 401(k)’s
You can only make “qualified charitable contributions” from an IRA. This option is not available for 401(k), 403(b), and other qualified retirement plans. If you wish to execute this strategy, you would have to process a direct rollover of your FULL 401(k) balance to a rollover IRA and then process the distribution from your IRA to charity.
The reason why I emphases the word “full” for your 401(k) rollover is due to the IRS “aggregation rule”. Assuming that you no longer work for the company that sponsors your 401(k) account, you are age 72 or older, and you have both a 401(k) account and a separate IRA account, you will need to take an RMD from both the 401(k) account and the IRA separately. The IRS allows you to aggregate your IRA’s together for purposes of taking RMD’s. If you have 10 separate IRA’s, you can total up the required distribution amounts for each IRA, and then take that amount from a single IRA account. The IRS does not allow you to aggregate 401(k) accounts for purposes of satisfying your RMD requirement. Thus, if it’s your intention to completely avoid taxes on your RMD requirement, you will have to make sure all of your retirement accounts have been moved into an IRA.
Contributions Must Be Made Directly To Charity
Another important rule. At no point can the IRA distribution ever hit your checking account. To complete the qualified charitable contribution, the money must go directly from your IRA to the charity or not-for-profit organization. Typically this is completed by issuing a “third party check” from your IRA. You provide your IRA provider with payment instructions for the check and the mailing address of the charitable organization. If at any point during this process you take receipt of the distribution from your IRA, the full amount will be taxable to you and the qualified charitable contribution will be void.
Tax Lesson
For many retirees, their income is lower in the retirement years and they have less itemized deductions since the kids are out of the house and the mortgage is paid off. Given this set of circumstances, it may make sense to change from itemizing to taking the standard deduction when preparing your taxes. Charitable contributions are an itemized deduction. Thus, if you take the standard deduction for your taxes, you no longer receive the tax benefit of your contributions to charity. By making IRA distributions directly to a charity, you are able to take the standard deduction but still capture the tax benefit of making a charitable contribution because you avoid tax on an IRA distribution that otherwise would have been taxable income to you.
Example: Church Offering
Instead of putting cash or personal checks in the offering each Sunday, you may consider directing all or a portion of your required minimum distribution from your IRA directly to the church or religious organization. Usually having a conversation with your church or religious organization about your new “offering structure” helps to ease the awkward feeling of passing the offering basket without making a contribution each week.
Example: Annual Contributions To Charity
In this example, let’s assume that each year I typically issue a personal check of $2,000 to my favorite charity, Big Brother Big Sisters, a not-for-profit organization. I’m turning 70½ this year and my accountant tells me that it would be more beneficial to take the standard deduction instead of itemizing. My RMD for the year is $5,000. I can contact my IRA provider, have them issuing a check directly to the charity for $2,000 and issue me a check for the remaining $3,000. I will only have to pay taxes on the $3,000 that I received as opposed to the full $5,000. I win, the charity wins, and the IRS kind of loses. I’m ok with that situation.
Don’t Accept Anything From The Charity In Return
This is a very important rule. Sometimes when you make a charitable contribution, as a sign of gratitude, the charity will send you a coffee mug, gift basket, etc. When this happens, you will typically get a letter from the charity confirming your contribution but the amount listed in the letter will be slightly lower than the actual dollar amount contributed. The charity will often reduce the contribution by the amount of the gift that was given. If this happens, the total amount of the charitable contribution fails the “qualified charitable contribution” requirement and you will be taxed on the full amount. Plus, you already gave the money to charity so you have spend the funds that you could use to pay the taxes. Not good
Limits
While this will not be an issue for many of us, there is a $100,000 per person limit for these qualified charitable contributions from IRA’s.
Summary
While there are a number of rules to follow when making these qualified charitable contributions from IRA’s, it can be a great strategy that allows retirees to continue contributing to their favorite charities, religious organizations, and/or not-for-profit organizations, while reducing their overall tax liability.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
