It’s hard to believe, but the fourth quarter is almost upon us. With it comes the inevitable hustle and bustle of the holiday season, and for many investors and advisors, a last minute rush to complete a variety of portfolio tasks before the end of the calendar (and tax) year. For some, this entails taking required minimum distributions (RMDs) from IRAs or looking for tax-loss harvesting opportunities in their portfolios. For others, year-end brings a focus on making last-minute donations to their favorite charities and causes.
The surge in charitable giving near year-end corresponds both with the aim of making annual gifts to valued organizations, as well as the desire to obtain tax deductions in the current tax year. Charitable giving is a very rewarding activity any time of year. It’s an opportunity to help others, and scientific studies have shown that giving actually makes you happier and healthier.
With so many great reasons to give, the question remains—how best to do so? Many individuals opt for the ease of writing a check, giving cash, or even putting a charitable donation on a credit card to earn cash back or other rewards. While the convenience factor of giving cash is certainly high, it may not be the most tax-efficient way to give for many investors. Here are two strategies investors can employ to stretch their charitable dollars and maximize their tax benefits.
Strategy 1: Donate Appreciated Securities
For investors with assets in after-tax (i.e. non-retirement) accounts, chances are you own some securities with unrealized long-term gains. These may be donated to a public charity, and you can claim the entire fair market value as an itemized deduction on your tax return—up to 30% of your adjusted gross income (AGI). Better yet, no capital gains taxes are owed on the appreciated securities, because the securities were donated, not sold. So the greater the appreciation, the bigger the tax savings will be – suggesting investors would be wise to donate their most appreciated assets first.
Let’s look at an example: Suppose a couple, Harriet and Bob, purchased some General Electric stock 20 years ago for $10,000, and it has since appreciated in value to $40,000. They would like to use the stock to make a one-time gift to their favorite charity, but aren’t sure of the best way to do it. Let’s also assume that Harriet and Bob’s taxable income places them in the 20% capital gains tax rate. If they were to sell the stock first and then donate the after-tax proceeds, they will owe a federal long-term capital gains tax of $6,000 on the $30,000 of gains, leaving $34,000 for their charity, which Harriet and Bob can claim as an itemized deduction on their tax return.
Now let’s suppose they were to donate the stock directly to the charity, rather than selling it first. Since no capital gains tax is owed when donating appreciated securities, the charity receives stock worth $40,000 and Harriet and Bob get to claim the entire $40,000 gift as an itemized deduction ($6,000 more in deductions than selling the stock and donating cash). So by gifting the stock directly to their charity, they have maximized the amount of the gift, as well as their tax deduction.
Strategy 2: Establish a Donor-Advised Fund
Now suppose rather than making a one-time gift of $40,000 to a single charity, Harriet and Bob were interested in spreading the gift to multiple charities, over multiple years. They could still donate the General Electric stock as described in strategy 1, but it becomes increasingly burdensome to coordinate smaller securities gifts with multiple charities year after year. Taking the strategy 1 approach also spreads the tax deduction across each of those years, rather than allowing Harriet and Bob to get the full deduction immediately. That’s where donor-advised funds help.
Donor-advised funds are public charities that accept gifts of appreciated securities and allow the donor to recommend grants that will be made to other charities of the donor’s choice. Many large financial firms (including custodian firms we work with, such as Fidelity and Schwab) offer these charitable vehicles, making it easy to contribute appreciated securities.
In the case of Harriet and Bob, they would make a single donation of the $40,000 of appreciated General Electric stock to a donor-advised fund of their choice and receive an immediate $40,000 itemized tax deduction. From there, they can then easily instruct the donor-advised fund to make grants to various charities, in various amounts, spread across multiple years. The process for requesting grants is straightforward and easy, and similar in nature to online bill pay. Once a grant has been recommended, the donor-advised fund mails a check to the charity and the donor has the option of having the gift made anonymously, or on behalf of the donors.
The flexibility and convenience of donor-advised funds make them our preferred method for making charitable donations in many situations. They provide the donor the ability to receive the tax deductions up front, and yet easily allow for multiple charities to receive grants over multi-year periods. In addition, they offer a cost-effective alternative to family foundations for high net worth families seeking to establish a long-term giving legacy that carries through multiple generations.
We have helped many clients establish donor-advised funds and would welcome the opportunity to discuss this flexible charitable giving tool with you.
As always, we recommend consulting with your tax advisor about the best approach for your unique situation before undertaking either of these two strategies. If properly employed, however, they represent great tax-advantaged ways to maximize your charitable gifts—making you and your favorite charity all the happier and healthier.