Charitable Donation Strategies
December 16, 2019 | Stanley K. Himeno-Okamoto, CFP®, CFA
You're in a giving mood and want to donate money to deserving charities, or you recently had a liquidity event and want to share some of your newly acquired wealth with good causes. The spirit of charitable donations isn't to minimize your tax bill or take the largest tax deduction possible, but if you're going to make the donation anyway, you might as well leverage tax laws as they currently apply. So, what's the best way to do it? Should you give cash or stock? Contribute to a donor advised fund and direct donations from there or make direct donations? What about charitable trusts?
Cash vs. Stock
Donating cash is the easiest way to make a charitable gift. You can write a check, give physical bills, make an electronic bank transfer, or sometimes even use a credit card. With cash, you're generally able to deduct donations up to 60% of your AGI from your taxes.
If you have appreciated stock held longer than one year, the maximum tax deduction is based on the fair market value of the stock, and only up to 30% of your AGI, but with the benefit that capital gains taxes on the donated stock will never have to be paid. For example, if you donate stock acquired at $0 that's now worth $50,000, you would owe nothing on the $50,000 appreciation while being able to deduct up to $50,000 from your taxes (or 30% of your AGI, whichever is lower). If you first sold the stock and then donated the cash, you would have to pay capital gains taxes on the $50,000 appreciation and be able to deduct from there.
Another consideration is donating highly appreciated stock that you want to continue holding. In the above example, you want to donate $50,000 but don’t want to give up your appreciated stock. Instead of donating cash or a different stock with less embedded gains, simply donate the highly appreciated stock like before, but simultaneously buy $50,000 worth of that same stock. Like before, the capital gains tax goes away, so your cost basis is effectively reset to the current price, and you still take the same tax deduction from your income as in the above example. Wash sale rules don’t apply here since they apply to securities held at a loss, and apply to securities sold, not donated.
If you have short-term capital gains stock (held for a year or less), your deduction would be the cost basis of your stock, rather than the current fair market value. It’s often more advantageous to wait until your holding period is longer than one year rather than donating short-term capital gains stock.
At the end of the day, the main limitation to donating appreciated stock is the 30% of AGI limit for deductions. Generally, donating appreciated stock will be better in the long-term because of the elimination of future capital gains tax liability. But if your income relative to your intended donation is low, this is one case when donating cash could be better. For example, if you wanted to donate $25,000 this year but have income of $50,000, you’d be able to deduct your entire donation amount if a cash donation, but only $15,000 if it was in the form of stock. However, if your donation this year exceeds the amount you can deduct due to your AGI, you’re able to utilize the carryover rule to deduct the excess in future years. This can get complicated though, as any changes to your tax filing status or additional charitable donations in future years will add layers of complexity.
The other hurdle to donating stock is that some charitable organizations don’t accept stock (though most major organizations do), and there’s an extra step in terms of transfer paperwork and determining which shares to donate. If you make small donations completely on a whim, it might not be worth the extra steps to donate stock. However, these issues can be addressed with a donor advised fund.
An important note: don't donate securities that are held at losses! In that case, it's better to sell them and donate the cash, since selling would allow you to realize the capital loss first. Donating capital loss securities prevents you from being able to take a capital loss.
Direct Donations vs. a Donor Advised Fund (DAF)
Like donating cash, making direct donations are the easiest way to direct funds to your charity of choice. The money goes straight from your bank or brokerage account to the charity's account. You choose exactly how much to donate, when to donate, and can always decide not to donate at any time.
On the other hand, donor advised funds (DAF) function like an intermediary charity designed specifically to distribute funds to qualified organizations at the donor's discretion. When you fund a DAF, it's effectively like making a direct donation to a charity - you get an income tax deduction, eliminate future capital gains tax liability, and can't ask the DAF to return the money if you change your mind. You can also manage the investments in your DAF, growing the value until you decide to direct your donations.
It may not seem worth the effort to open and fund a DAF, but they serve several very important purposes.
Maybe you know that you want to donate to charitable causes but don't know which ones yet. Especially if the end of the year is creeping up, a DAF will buy you some time while you figure out where you want to donate. You can even let the funds grow over several years before ultimately donating.
Do you normally take the standard deduction on your taxes or have itemized deductions not much higher than the standard deduction? One potential strategy is to fund a DAF in alternating years. More of your deductible contributions will apply above the standard deduction in the funding years, creating a tax benefit due to timing. Using a DAF to execute this strategy allows you to continue making donations every year (half of the contribution in the funding year, and half in the next) even though you’re only funding the DAF every other year.
What if you had a large liquidity event that led to unusually high income? Your tax deduction would be larger if you're in a higher tax bracket, so if you've been pushed into the top tax brackets because of the liquidity event, you could benefit from loading contributions to a DAF in high-income years, and not contributing (or contributing much less) in lower-income years. Prior to the Tax Cuts and Jobs Act of 2017, the Pease Limitation phased out itemized deductions after income hit a certain threshold, reducing the effectiveness of donating in high income years. The Pease Limitation is gone (for now), so maximizing deductible contributions in high income years is a viable strategy.
If your charity of choice doesn’t have the capability to accept stock, you aren’t stuck holding highly appreciated stock or forced to take the capital gains tax hit by selling it. Instead, you can contribute the highly appreciated stock to the DAF and then sell the stock. DAFs are tax-exempt entities so sales within the account aren’t subject to taxes. Then, you can send cash to the charity.
Charitable remainder trusts and charitable lead trusts are ways to make an irrevocable charitable decision with the split goal of providing either income or a lump sum to other beneficiaries. These are powerful tools in the estate planning process, and the near infinite customizability allows grantors to tailor their charitable trust to fit their unique requirements. With customizability comes complexity, and a deep dive into charitable trusts is beyond the scope of this piece.
Charitable trusts require careful coordination with your advisors - estate attorney, CPA, financial advisor - to ensure you're making the best decision for you and your beneficiaries and executing it with a bulletproof legal framework.
If you want to discuss strategies for charitable giving, schedule a time to speak with a ClearPath financial planner, or send us an email.
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