Donor-advised funds are investment tools that have become increasingly popular for high-net-worth taxpayers. A donor-advised fund (DAF) is administered and operated by a public §501(c)(3) charity (referred to as a sponsoring organization). Taxpayers can participate in this investment vehicle by opening an account with the sponsoring organization and contributing money or other property. The sponsoring organization controls the assets, but the taxpayer remains an advisor for how the assets are invested as well as how and when distributions are made to a qualified charitable organization. DAF contributions are irrevocable, which means these contributions are most often qualified charitable deductions for the taxpayer. This vehicle is similar to a private foundation, although foundations have a much higher administrative cost than DAFs. Following are several planning techniques and tax benefits of DAFs.
One of the simplest ways to reduce taxable income is by making charitable deductions, not to mention the critical impact of charitable giving on the community. Donor-advised funds can be set up to automatically draw money from the taxpayer, making the process of giving simple and requiring minimal planning. Donor-advised funds are also flexible enough to allow for adjustment by the taxpayer in years where income may change drastically or where other economic events might impact the taxpayer.
Those who contribute to the DAF have a level of input on how the funds are used and flexibility in what funds they contribute. One important use of a DAF is to rebalance investment accounts and reduce overall capital gains. When a taxpayer contributes appreciated assets, they receive a charitable deduction for the asset’s fair market value and avoid capital gain tax that they otherwise would have owed. These contributions are irrevocable, so while a taxpayer may avoid paying capital gain tax, they will lose any investment benefits from the asset. These assets will continue to grow within the DAF tax-free until the sponsoring organization sells them.
Support Operation of Charities
As mentioned previously, a taxpayer contributing to a DAF will retain some influence on how the funds are to be used. However, as it is an irrevocable contribution, they do not have any decision-making authority. Decisions are ultimately up to the DAF board. Despite this, the taxpayer can utilize the tax benefits of a DAF while allowing for their assets to grow tax-free, and when the time is right, these funds could be used to help a cause close to the taxpayer.
Overall, a donor-advised fund is an efficient tax planning tool for high-net-worth taxpayers interested in charitable giving. They can be used to reduce capital gains tax while also providing the taxpayer with a charitable deduction for the value of the assets contributed. However, to receive these benefits, the taxpayer must make an irrevocable contribution, relinquishing decision-making authority in the process.
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