Save Taxes! Establish A Donor Advised Fund

by: R. Paul Drake
Summary

The current tax laws may not reward one for modest charitable contributions.

By planning ahead and establishing a donor-advised fund one can reap tax benefits.

If you now give a few thousand dollars or more a year, and would normally take the standard deduction under the 2018 tax law, then you could save on taxes.

Here I describe why and how I set up my own fund.

Are you taking the standard deduction under the new tax law? Do you wish you could get some tax reductions for your charitable contributions, like you used to? There is a way, but it requires planning ahead. I share my path through this issue here.

In 2018 I ended up taking the standard deduction. Only $10k of my state and local taxes (SALT) were deductible. That plus mortgage interest plus my charitable giving did not get above the $24k standard deduction. So I got no tax benefit from the contributions. I favor simpler taxes, and so would not complain if that were the end of the story.

In my reading, though, I came to realize that Congress has left a way to get a much larger deduction associated with charitable contributions. You just need to give more! Doing so every year is not in the cards for me right now, but there is a wrinkle.

It has become really easy to establish your own charitable giving fund. We used to think of private foundations as the province of the Gates and the Buffetts. But today most brokers offer an equivalent as a service to their clients. So I decided to think through the question of what to do, and act on the result.

How Much to Move Into a Donor-Advised Fund?

Charitable giving is part of my long-term financial planning. It is, or has been, included in my projections for what I will want to spend in retirement. Being on the edge of retirement, I have the funds whose purpose is to generate this income. So the option of setting aside some funds for this purpose in advance is reasonable. This is likely true of many readers.

For this article, I will consider a goal of setting aside a total of $100k to support an ongoing $8k of donations, give or take, for however long the money lasts. Because the full $100k seems like a lot of money to me, I will compare doing this all at once or as two contributions of $50k, spaced a few years apart.

Your own details likely depend on how much deductible mortgage interest you are paying. If this is $14k or more, or you have other deductions that add up to that much, then all your charitable contributions are deductible. You may still want to consider a donor-advised fund, but not from the perspective of immediate taxes.

I could save the most taxes by fully endowing the charitable contributions. For the numbers used here (5% yield and 8 k$ donations), this would require a transfer of $160k. That is definitely too steep for me now. Ultimately, I decided to split the near-term donation into two parts, separated by a few years. I view the extra costs as insurance against the potential horrid futures envisioned by some commenters on Seeking Alpha.

My Choices While Maximizing Withdrawals

I put together a spreadsheet to look at some options for myself, with results shown in Table 1. The perspective behind the calculation is this. My goal is to place my taxable income at $315k, the top of the 24% tax bracket. This is the top of the tax brackets in the low-20% range. It generates a tax bill of $64k this year. The $315k limit will increase with inflation in later years, but this does not affect the differences that matter here so I will ignore this aspect.

As discussed in a previous article, the point of ending up with that specific taxable income, which is more than my operating needs, is to convert the additional funds from traditional IRAs to Roth IRA or after-tax funds.

After taxes and charitable giving, one ends up with some total amount for other expenses and after-tax (or Roth) savings. This is shown in the rightmost column. Since I anticipate paying off my mortgage soon, I evaluated the results for before and after the payoff.

Table 1. Working out the impact of various possible decisions.

SALT

Mortgage interest

Direct to charity

To Donor-advised fund

Deductions

Gross Income

Net funds after fed taxes & charity

With mortgage

10

6

0

0

24

339

275

10

6

8

0

24

339

267

10

6

0

50

66

381

267

10

6

0

100

116

431

267

After payoff

10

0

0

0

24

339

275

10

0

8

0

24

339

267

10

0

0

50

60

375

261

10

0

0

100

110

425

261

The table has a lot to it, but the structure is simple. The first line in each section, in bold text, shows the case where the only deductions are SALT deductions and mortgage-interest deductions, shown in the second and third columns, respectively. This row assumes zero other deductions. The idea is that this would be the normal state of affairs, in years when the donor fund is making the donations.

Taking a gross income such that the taxable income is $315k leaves $275k after taxes for spending or saving (and state taxes). The spending includes everything except any charitable donations, whether direct or to the donor fund. The fourth and fifth columns in the table show these.

The next row in the table shows what happens if I donate $8k each year. So long as my mortgage exists, the money that ends up available for other spending or saving is $267k. But here is the difference. If I donate $8k each year, I end up with $267k every year. In contrast, if I transfer money into the donor fund in the first year and donate from it after that, then I will have $275k for non-charitable spending, as long as the money in the donor fund lasts.

The next two rows in the table show how it goes with the donor fund. In the case of a $50k transfer and a 5% yield on the funds, the money will last 8 years. I will have $8k more money to spend in 7 of these, for a total of $56k. If I transfer $100k, the funds last 19 years and over those years I will have an additional $144k. The difference between $56k and $144k is smaller than it appears. The present discounted value of the two streams of payments is $46k and $94k, respectively.

The choices are similar if one considers the alternatives after the mortgage has been paid off, shown in the lower half of the table. The maximum amount for spending and saving remains $275k. But now in any year that one puts substantial funds into a donor account, there is a need to make up for the lack of a mortgage interest deduction. The upshot is that one nets $6k less, and so has $50k (rather than $56k) more to spend or save if one puts $50k in the donor account. The similar number for transferring $100k is now $138k rather than $144k.

Similar Results if Seeking Fixed Income

Perhaps you do not choose or need to pull funds from a Traditional IRA to somewhere else. The results are similar. Suppose you need about $122k after taxes and charity, and that you make $8k of annual charitable deductions. Taking the standard deduction, you would withdraw $150k from your portfolio to provide this.

In a year when you had to make no charitable contribution from new withdrawals, you would only need $140k from the portfolio to provide the required $122k. To fund a $50k donor fund, you would withdraw 192k$ in the first year and deduct all of it plus the (SALT) and mortgage interest, still paying the same taxes and ending up with the same spendable funds after charity.

If the $50k lasted 8 years, during 7 of them you would save a total of $70k in needed withdrawals, partially offset by the extra $42k needed in year one to establish the donor fund. Thus, you would need to withdraw on average $4k less funds each year from the portfolio.

Setting up and funding the fund

I work through Fidelity, which has a separate website devoted to such accounts, at fidelitycharitable.org. The charitable fund site is well done and clear. You need to know what you want to name the fund, the name of a contact, and personal details for anyone allowed to control it. As part of the process, you can transfer funds from an after-tax account in order to establish the fund. The minimum initial contribution is $5,000, so I transferred that in order to create the fund.

In the Fidelity universe, and perhaps elsewhere, you are not allowed to transfer cash or securities directly from an IRA or other tax-deferred fund to a donor-advised fund. You must instead pull the money out into an after-tax fund, and then subsequently transfer it to the donor-advised fund. So I decided which investments to sell and did so.

Once these sales had cleared, I moved the funds. With Fidelity, moving the money from an IRA to an after-tax brokerage account includes a step where one specifies the amount of income tax withholding. I adjusted the amount to zero, because I will end up with a $50,000 tax deduction once the donor account is fully funded.

A few days later, I set out to move the money from my brokerage account to the donor account. But I got derailed. I read the various notices and disclaimers, only to find that one does not have complete freedom in selecting the recipient. This is true at least with Fidelity and I expect with all brokerages. They are presumably protecting themselves legally.

One is limited to organizations that have established themselves with the IRS as 509((a))(1) Public Charities. What the heck? I’m used to expecting 501((c))(3) status, in order for contributions to an organization to qualify as tax deductible. It turns out that these organizations are classified by default as Private Foundations by the IRS. To become qualified as Public Charities they must also apply for 509((a))(1) status, showing with a five-year record that they get most of their funding from a wide range of contributors. (I’m approximating the details here.)

Having learned about this, I backed out of transferring funds and went to the page where I could attempt to give them. On the Fidelity version, there is a search box where you type the name or Tax-ID of the organization and find out if they are known by Fidelity to be qualified. I checked on several of the organizations to whom I make my larger donations, and all were recognized.

The important impact for you is that if you have very new organizations to whom you wish to contribute, you might have to wait a few years before you can do it with a donor-advised fund. This will apply to one of my charities, so I may decide to give them more money this year when it will be tax-advantaged and less in the next few years.

The IRS also has a requirement on the long-term rate of giving. One must give an average of 5% annually, on a rolling five-year basis. This limit is small enough not concern me.

After these detours, I went back to GO and transferred the remaining $45,000 into the donor account.

Another aspect of the Fidelity system is that, unless one contributes $250,000 or more, one is relatively limited in the investment options. The options resemble those in a small, limited, employer 401k account. There are several integrated options. (I chose “balanced” to start with.) There are also sector-specific options, such as US Equity, Money Market, and International Equity. There are also some Sustainable options. One can distribute one’s donations across the investment options as well.

Alternative Routes to Funding Donor-Advised Accounts

I tried to explore alternative ways of funding these accounts, because some readers will be interested. I did not actually execute any of them, though. This is what I seem to have learned:

If you hold appreciated securities already in a brokerage account, then you are allowed to transfer these securities to the donor-advised fund and to avoid taxes on the appreciation. This presumably is true everywhere. For Fidelity, to transfer the securities you must use the paper form, available as the Contribution Form via the Forms link at the bottom of the main Fidelity Charitable web page.

Fidelity Charitable, and likely other organizations, will not continue to hold the security in the donor account. You avoid the taxes on the appreciation, but they will sell it and put the funds in the options you designate, described above.

Vanguard and elsewhere report that current law does not allow direct contributions to a donor-advised fund from traditional IRAs that are subject to required minimum distributions (RMDs). In contrast, within some limits, one can use RMDs for tax-free donations to 501((c))(3) charities. Subject to fewer limitations, one can also donate appreciated securities from traditional IRAs to such charities but not to a donor-advised fund.

I also checked about appreciated securities in a Roth IRA. There would be no tax advantage to donating them directly, but it might be a convenience. A Fidelity representative did tell me that I could transfer securities from a Roth IRA into a brokerage account, subject to the usual five-year rules. One could apparently transfer securities from the Roth IRA to the brokerage account and then to the donor account, using the paper form described above. There would be no tax benefits, of course. I was told that one cannot transfer securities directly from a Roth IRA to a donor-advised fund with Fidelity.

Donating from the Fund

The point of all this is to enable actual giving, so I tested that next.

I proceeded to give minimum ($50) gifts to four of my charities, as a test to see how the process went. It was straightforward enough. One searches for the charity. I found all of mine, but sometimes their name in the database was not what I expected or remembered. You need to get close enough to the actual name for the search to work. Alternatively, if you have a tax ID number for the charity, that will work.

One slightly tricky thing is that after making your selections, you have to find and use the “next” button down at the lower right, which takes you to a page where you certify that you accept the rules and click on “submit”.

It turns out that you may or may not get any acknowledgment from the charity itself. I learned the following from speaking with a Fidelity representative. When charities receive contributions from donor-advised funds, they are not legally required to acknowledge them. There is no further tax benefit to you, so you don’t need further documentation.

Personally, I prefer to get email acknowledgements of my larger donations. It turns out that one cannot do this through the drop down “Acknowledgement” menu. That menu gives you the choice of using just the Fund Name or that name and also the contact information you provided. This likely will be your own name and address.

If you want an acknowledgment by email, then you can click the menu labeled “Use” and edit the “Create your own” item. There you can say what it should be used for and also can ask that they send an acknowledgement to your email address. I personally will do this for my larger donations, for which I tend to know people at the charity.

I submitted my test grant requests on a Saturday evening and saw Monday that they were approved that same day. From this it seems that the approval process must be automated. If your desired grantee has the right IRS status, then it appears that you are OK. Each of the ones I checked personally so far have been listed as a “research charity”.

On Tuesday morning, the Grants History link showed that the status was now “issued.” Later Tuesday, I received an email entitled “Grant Recommendation Confirmation” for each of the grants I requested. This directed me through links on the website to a page where I can view the letter and the check issued to each recipient.

It appears to me that this is the end of the process.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not a financial adviser or a tax advisor, but am an independent investor. Any securities or classes of securities mentioned are not recommendations.