This year — clearly a highly unusual one in so many ways — there is even more need to carefully review philanthropic options that also have tax advantages.
As we enter the holiday season, many naturally turn their thoughts to charitable giving and yet, for the first time in nearly two decades, only half of U.S. households donated to a charity, according to a study from 2021 that is published every other year by Indiana University’s Lilly Family School of Philanthropy[i]. In the wake of the COVID-19 pandemic unemployment and food insecurity soared. In 2021, 53 million people turned to food banks and community programs for help putting food on the table, according to Feeding America[ii].
Taxpayers have until the end of the year to meet IRS deadlines, take advantage of tax rates that are locked in and qualify for charitable vehicles that are currently in place. There are two strategies they may want to consider: charitable lead annuity trusts and donor-advised funds. Note: these strategies tend to work best for those who can afford to designate a proportion of their income to charity on an ongoing basis.
An Under-the-Radar Option
A charitable lead annuity trust is a philanthropic option that’s a bit under the radar. It can be a good fit for those who have recently received a large influx of cash from, for example, selling a business or investment. It’s also an option for those who haven’t been able to deduct as much they’d like from their taxes.
The trust allows a donor to give cash, stock or real estate to a trust while offsetting income tax in the current year and potentially future estate taxes.
Even Jacqueline Kennedy Onassis included a charitable lead trust in her will, perhaps attracted by this benefit: Whatever assets are left in the fund at the end of the fixed term go to the donor’s beneficiaries tax-free.
A huge reason charitable givers should think about this kind of trust now: the lower the starting interest rate, determined by Section 7520 of the IRS code, the more the donor and his or her beneficiaries may benefit.
No Double Dipping
An upfront tax deduction and the ability to reduce estate and gift taxes — as well as the potential to pass on assets to heirs — make charitable lead trusts potentially very appealing.
But there are caveats. The funds in the trust are subject to investment management risk. After the initial tax deduction, donors can’t take any more deductions. No double dipping. Also, any capital gains or losses inside the trust flow back to the donor.
Charitable lead annuity trust are very complex vehicles. In addition to consulting with attorneys and accountants, it’s critical to work with a financial adviser to make sure any use of the trust is part of a holistic plan that aligns with your overall goals and interests.
Calling the Shots
Donor-advised funds (DAFs) are another attractive option for those who may have had a windfall this year or a bump in income. DAFs are a viable alternative to writing a check directly to a qualified organization or, for those with substantial wealth, starting a private charitable foundation.
Nonprofit divisions of financial service companies and other third parties, such as a community or church group, administer and legally control donor-advised funds. But as the name implies, individuals or families who set up the funds retain the ability to suggest or advise on where the funds should go.
The donors retain the ability to suggest or advise the donor on fund distributions.
Donors designate which IRS-designated 501(c)(3) charities receive money from the fund. They can change which organizations receive money and how much they get as often as they want.
What’s more, DAFs can be more attractive than family foundations because donors don’t have to worry about legal and administrative fees and can start one with as little as $5,000.
Any gift for the fund is an immediate tax deduction and the donor isn’t required to distribute it immediately. If you’re unhappy with the way one charity is operating, you can switch the distribution to one you like better. The donor calls the shots.
The tax benefits of a donor-advised fund are similar to contributions to religious institutions, colleges or public charities. Taxpayers who itemize can write off their cash donations up to 50% of the adjusted gross income. Those donating stock, real estate or any other asset that has appreciated can write off up to 30% of adjusted gross income. The unused amount can be carried forward up to five more years to be used as a deduction against income.
DAFs can serve as an appealing tax strategy for someone holding highly appreciated stock. If you were lucky enough to buy 100 shares of Apple (AAPL), 1.80% in 2008, for example, you can claim the current price of the stock as your tax-deductible donation. Meanwhile, the fund sells the stock and keeps the proceeds, but you don’t have to pay capital gains tax. In that way, you optimize your financial liabilities and make a powerful gift to charity at the same time.
People do need to keep in mind that once a donation is made to a DAF, it’s a completed gift. There’s no going back.
How Much in Benefits?
The tax benefit depends on your effective tax rate. For philanthropic options like DAFs, the benefit is not necessarily how much more you get in tax savings today, but the control you maintain over your donation.
And in the case of a charitable lead trust, it’s the ability to potentially retain some of your money down the road in the form of a tax-free payment to an heir or a beneficiary when the term of the trust runs out.
For both these strategies, financial advisers play a crucial role.
They will — or should — have a comprehensive plan for you and can identify whether the strategy is appropriate. Does it make sense for you or not?
Advisory firms will walk you through the financial planning process to make sure the tax or philanthropic option is truly viable.
You never want a complex strategy involving significant assets to be a one-off, where you’re just trying to get an edge on your taxes. You have to know how it affects the other pieces of your overall plan.