Donor-Advised Funds and Qualified Charitable Distributions: Two Strategies to Consider Before Year-End
As we approach year-end, charitable giving tends to become a more frequent topic of conversation. Many faculty members support the same organizations year after year, and year-end is often when they begin to consider whether there may be a more tax-efficient way to give.
While writing a check remains the simplest approach, it may not always be the most effective from a tax-planning perspective. Depending on your age, income, investments, and retirement assets, there may be ways to make your charitable giving more tax-efficient without changing the causes you support or the amount you give.
Two strategies that often come up in planning discussions are donor-advised funds (DAFs) and qualified charitable distributions (QCDs). Both can be effective giving tools, but they work very differently and may suit different situations.
Donor-Advised Funds
A DAF can be a useful tool for those who are already planning to make charitable gifts but want more flexibility around the timing. When you contribute assets to a DAF, you may be eligible for a charitable deduction in that year if you itemize. The funds can then be distributed to the charities you support over time. While cash is always an option for funding a DAF, you can also contribute appreciated securities from a brokerage account.
Following the strong market returns of recent years, investors might find themselves holding stock positions with significant unrealized gains and, in some cases, those investments have also grown to represent a larger portion of the portfolio than originally intended. When considering which securities to donate, those with larger unrealized gains may be worth evaluating before those that have performed poorly.
When those positions are held in a brokerage account, selling them generally results in capital gains and taxation. Rather than selling appreciated securities and donating the cash, contributing the securities directly to a DAF may allow you to avoid recognizing the gains while potentially qualifying for a charitable deduction for their value, assuming they have been held for more than one year and you itemize. The assets can then be sold inside the DAF, and the proceeds can eventually be distributed to charities of the donor’s choosing over time.
While every situation is different, DAFs may become more valuable when one or more of the following circumstances exist:
- An investor owns appreciated securities with significant unrealized gains.
- A portfolio contains a concentrated stock position that has grown larger than intended.
- Income is unusually high in a particular year.
- The individual wants to combine several years of charitable giving into a single tax year.
That last point has become more relevant since the standard deduction increased several years ago. Rather than giving annually and receiving little additional tax benefit, some individuals “bunch” multiple years of anticipated giving into a single year, and a DAF is one way to do this. Doing so may create enough deductions to itemize that year, with the option to return to the standard deduction in later years.
DAFs are not without tradeoffs. Contributions are irrevocable, meaning the assets can no longer be used for personal spending needs. In addition, a larger DAF strategy requires having assets available to contribute upfront. While there may be tax benefits, individuals should also be comfortable making a permanent charitable commitment.
Qualified Charitable Distributions
A qualified charitable distribution allows individuals age 70½ or older to transfer funds directly from an IRA to an eligible charity. Unlike a typical IRA withdrawal, the amount distributed through a QCD is excluded from adjusted gross income (AGI).
Because many tax calculations are tied to AGI, a QCD may offer benefits beyond the gift itself by keeping the distribution out of AGI. As a result, lower AGI may influence several income-based calculations, including Medicare premiums, which are based on income from two years prior. QCDs are also frequently discussed alongside required minimum distributions (RMDs). For individuals who are already required to withdraw funds from their IRAs each year, a QCD may satisfy all or part of that obligation while simultaneously supporting a favorite charitable organization. For example, if your RMD from your IRA this year was $10,000 and you made a $2,000 QCD to a charity you support, you would only need to withdraw an additional $8,000 from the IRA. As a result, the $2,000 QCD generally would not be included in taxable income, while the remaining $8,000 distribution generally would be taxable, assuming the applicable QCD requirements are satisfied. With the increased standard deduction in recent years, many taxpayers are not receiving a tax benefit from their charitable giving. Because a QCD reduces AGI rather than creating an itemized deduction, it may provide a tax benefit for some individuals making charitable gifts while continuing to claim the standard deduction.
While every situation is different, QCDs often become attractive when an individual:
- Is age 70½ or older.
- Holds a significant portion of assets within an IRA.
- Is taking required minimum distributions.
- Would benefit from reducing adjusted gross income.
Like DAFs, however, QCDs have limitations. The strategy is only available to those age 70½ and older, and the funds must come directly from an IRA. Employer retirement plans such as 401(k) and 403(b) plans are not eligible sources for QCDs. They also come with annual limits and tax return reporting requirements that you need to follow for the tax treatment to apply correctly.
Which Strategy Is Better?
Neither strategy is inherently better than the other. DAFs and QCDs are not competing strategies. Rather, they solve different planning challenges.
A DAF may be attractive for someone with highly appreciated investments, a concentrated stock position, or an unusually high-income year. A QCD may be more appealing for someone who is already taking distributions from an IRA and wants to reduce adjusted gross income.
Some individuals may use both strategies over time. For example, someone may make a large DAF contribution in a year when income is elevated or when they want to reduce a concentrated stock position. In later years, they may shift toward QCDs to support their charitable goals while managing taxable income from retirement accounts.
For charitably inclined individuals, both donor-advised funds and qualified charitable distributions may be effective planning tools. What makes sense for one individual may not make sense for another. The challenge is not determining which strategy is universally better, but rather which strategy may be more appropriate given your specific circumstances. Factors such as age, income, portfolio composition, where assets are held, retirement account balances, and charitable goals can all influence the analysis. There can also be additional tax considerations beyond the concepts discussed here, which is why a personalized review with a CERTIFIED FINANCIAL PLANNER® professional is often valuable.
If charitable giving is already part of your financial plan, year-end can be a good time to revisit how you make these gifts. A thoughtful review may help identify opportunities to improve the tax efficiency of your giving while continuing to support the same organizations and causes that matter most to you.
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment or tax advice from Savant. Please consult your investment or tax professional regarding your unique situation.
Noah J. Tostrud
Financial Advisor
CFP®