[Editor’s Note: Today’s guest post was submitted by Wesley Botto, CPA, Partner, and Financial Advisor at Botto Financial. This is not a sponsored post, however, Botto Financial is one of our WCI Recommended Financial Advisors. They are currently offering a free consultation for any WCI reader that wants to explore whether or not a donor-advised fund is a good fit for them. We have written before about DAFs, here and here, but it has been over a year and a half. Enjoy the post.]
A Donor-Advised Fund (DAF) can be a powerful tool. Because of this, more people are becoming aware of the benefits. Many people ask, “Should I open a Donor Advised Fund?” This may seem like a simple yes or no question, however, there are multiple factors to consider.
Do You Have a History of Giving to Charity?
The first question that needs to be asked is: Are you already giving to charity? In my experience, if someone answers “No, but…” there might be a perfectly good reason why they aren’t giving to charity now. However, that does not mean that their first foray into charitable giving should be with a DAF.
Don’t Rush into a DAF if You Are New
Unless there is a one-time event (such as the sale of a business or other taxable event), there should not be a rush to jump into a DAF. Potentially, if someone is nearing retirement, there might seem to be a rush. However, if there is not a history of charitable giving, it can cause problems. If there is not a history of charitable giving, it is less likely for the donor to understand the utility of a DAF. A DAF introduces some (but not a lot) of complexity that could be avoided by not jumping in before you know you are ready.
How to Start
For the person that does not have a history of charitable giving but would like to start, I suggest planning out your charitable gifts. Decide which charities you are passionate about. Get excited about making an impact with them. Give it a year and then re-evaluate to determine if you want to jump into the (slightly) deeper water of a DAF.
For the person that has a history of giving to charities, the next question is:
Why Are You Considering a DAF?
Everyone is always looking for a tax break (and rightfully so). In order to ensure you will actually get a tax break, you need to understand the situations when a DAF is beneficial:
You Will Make Lifetime Charitable Contributions
If you plan to make charitable contributions for your entire life, including the years when you are not working (thus have a lower income) a DAF is a great tool to maximize your deductions during your earning years. Assuming that the tax rates stay relatively similar to today (even with the TCJA sunset in 2025, the rates will not be too different), then you will likely have a much lower income in retirement, thus reducing the value of a charitable deduction. There’s a high likelihood that you won’t even itemize in retirement, which further increases the value of contributing to your DAF during working years. If you spent your working years building up a DAF, you will spend your retirement years making DAF distributions to your favorite charities, and they will not know the difference.
You Utilize a Bunching Strategy
The “bunching strategy”: this is where you give to a DAF in addition to making your normal annual gifts. It is important to do an analysis to make sure that this strategy is going to be worth the hassle. Here’s how you do it:
If you currently are not itemizing and you use the standard deduction, this could be a useful strategy.
If you are already itemizing, calculate your itemized deductions EXCLUDING the charitable deduction. This measures the impact that the bunching strategy will have. If the difference between your deductions less charitable contributions and the standard deduction is not significant, the bunching strategy will be a lot of hassle for little benefit.
For example, in 2019 the standard deduction is $12,200 for single filers and $24,400 for married filing joint. If your deductions excluding charitable gifts equal $23,000 (married filing joint), the bunching strategy will only give you an additional $1,400 in deductions – and it won’t be every year.
If you’ve done the above analyses and determined that the bunching strategy may still be of value, you should understand how a donor-advised fund works.
[Editor’s Note: Note that bunching does not require a DAF. You can simply give two years worth of contributions to the charity at once. For example, you give your 2020 contribution and your 2021 contribution on January 2nd, 2021, take the standard deduction in 2020 and itemize your deductions in 2021. You only need the DAF if you want to take the deduction now but not give the charity the money until later, a move I have affectionately referred to in the past as the “jerk move.” Alternatively, you can donate “for 2020” on January 2nd, 2021 and “for 2021” on December 28, 2021. The donations are a year apart, but you get to take the deductions all on your 2021 taxes.]
How a Donor-Advised Fund Works
Donor-advised funds have become a popular alternative to charitable foundations. Charitable foundations have more red tape, required tax filings, and more hoops to jump through. Donor-advised funds offer many of the tax advantages of charitable foundations without the hassle.
Charitable Tax Deduction
When you contribute to a donor-advised fund, you receive a charitable deduction in that tax year (subject to charitable contribution limits). Keep in mind that once you make the contribution to a donor-advised fund, the money is no longer yours – the funds must eventually end up with a qualified charitable organization.
Contributions Can Be Invested
Another advantage of a donor-advised fund is that it allows you to invest the money within the DAF. This can put you in a position to have your own “charitable endowment.” For example, it could be a goal of yours to build up your DAF to $25,000. If you invest the fund in a manner where you can achieve an annual 4% rate of return (a modest and attainable goal) then you will be able to make gifts of $1,000 in perpetuity. The more you add to the DAF, the more you can give on an annual basis.
One of the pitfalls of a DAF is the expenses. The DAF will be held with an institution that charges an annual fee (typically taken out of the balance of the fund). You will want to take this into account.
One of the most exciting aspects of a DAF that I have not mentioned yet is how you can create a multi-generational legacy of giving with a DAF. If you continue to make gifts to your DAF and only disburse the growth, your DAF can last as long as you want. It will enable you to bring your kids into very fun conversations about making an impact on causes that are important to your family. That has the potential to instill generosity in them that can extend for many generations.
I hope that this article does not come across as recommending against using DAFs. I am a big proponent of them as part of a charitable giving strategy. DAF’s are a creative and fun tax and charitable planning tool to consider in your own strategy. However, it is important to go in with your eyes wide open and understand when it makes sense. It may be best to continue making gifts of appreciated stock, or cash in the short-term with a long-term goal of opening up a DAF.
What do you think? Do you use or are you considering a donor-advised fund for charitable giving? Why or why not? Comment below!
The post Should You Use a Donor-Advised Fund? appeared first on The White Coat Investor – Investing & Personal Finance for Doctors.