Advantages of Donor-Advised Funds: Tax Reduction and Charitable Giving Perks
It comes as no surprise that during and after retirement years, many of our clients achieve their highest income earning potential. Whether due to a large severance package on top of earned income, or non-qualified deferred compensation plans that force large taxable payouts, retirees are often pushed into the highest tax bracket during these years.
The question we receive from most of our clients during this time then is, “How can I reduce my tax burden?”
For clients who are charitably inclined and who are committed to continue donating to their favorite charities throughout retirement, we often recommend that they consider using a donor-advised fund (DAF). The beauty of donor-advised funds is that they allow an individual to receive the tax deduction for a large charitable donation on the front end, while spreading out the actual donation of the funds to charities over multiple years.
A donor-advised fund can be funded with cash, securities, and in some cases, non-publicly traded assets. Only a small donation to charity from the fund is required each year, and you can wait until you are ready to make a grant out of the fund to the charity of your choice. In addition, while you wait to make your donation from the fund to charities, the cash and securities inside the fund can be invested and any growth is tax-free. The funds can also be used to fund a charitable legacy for your family, and are a much less complex and less expensive alternative to setting up a family foundation.
Understanding Donor-Advised Funds
To better understand the benefits of a donor-advised fund, let’s review the following example. Joe Smith, 59, is an executive at a Houston oil company, where he worked for 25 years. He and his wife, Jane, have three children. He opted to take early retirement, effective September 2016, and will receive a large severance package. In addition, his company sponsors a non-qualified, deferred compensation plan that forces out the entire balance immediately after retirement, and is taxed at ordinary income rates.
Joe and Jane are very charitably inclined and donate approximately $20,000 per year to a select charity that is important to them. Joe and Jane would like to pass the value of charitable giving on to their three children, and leave a charitable legacy in their community. With Joe’s severance payout and non-qualified plan payout, his total earned income for the year will be over $1,000,000 and the majority of his income will be taxed in the maximum 39.6% tax bracket.
Joe and Jane decide to open up a donor-advised fund to alleviate some of their tax burden this year. They make a contribution of $300,000 to the fund. They are able to put the entire $300,000 contribution on their tax return as a charitable donation. This amount is sufficient to provide for the Smith’s charitable contribution of $20,000 for 15 years. In addition, while the $300,000 cash sits inside of the donor-advised fund, it can be invested, allowing for additional growth of the fund for donation to charity. The growth portion of the cash inside of a donor-advised fund grows tax free and will never be subject to capital gains taxes.
Another option Joe can utilize to contribute to the donor-advised fund is appreciated securities, which provide further tax benefits. By donating appreciated securities to the fund, Joe will avoid paying capital gains on the growth of the securities and he will get the charitable deduction.
Furthermore, Joe and Jane name their fund the Smith Family Foundation and name their three children as successor owners. They allow their children to assist with making the charitable donation from the fund each year, and this helps them pass along their charitable values. The fund allows Joe and Jane to make a donation to any public charity recognized by the IRS. This flexibility allows Joe and Jane to leave an impact on their community by donating to the charities of their choice.
By using the donor-advised fund, Joe and Jane Smith are able to accomplish many of their financial and charitable giving goals. They receive a large tax deduction in the year of highest income by ‘pre-funding’ charitable donations for future years. While they make the donation to the fund this year, they are able to spread the donations to the charity of their choice over as many years as they choose.
If they choose to make their contribution using appreciated securities, they also can take advantage of capital gains tax avoidance. Joe and Jane are also able to pass their charitable values along to their children, and can leave a legacy in the community that they care about without having to deal with the complexity of setting up a private foundation. Many of the clients we work with experience the same challenges as Joe and Jane during their retirement years, and we have helped many who are charitably inclined with the use of a donor-advised fund.
If you would like to speak with us about your goals and specific situation to see if a donor-advised fund could benefit you, please contact us to set up a conversation.
Willis Johnson & Associates is a registered investment advisor. This material is intended for informational purposes only and is not intended to be a substitute for specific individualized tax or legal advice. Federal tax laws are complex and subject to change. Neither Willis Johnson & Associates, nor its investment advisor representatives, offer tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.