November 30, 2022 – As we head into the holiday season and address year-end planning for 2023, now is a good time to reflect on charitable donations and how to best facilitate them. Contributing to a meaningful cause is a worthwhile endeavor, whatever your reasons are. It’s important to understand what you are trying to achieve and select a strategy that helps optimize your gift and wealth planning objectives.
What Type of Donor Are You?
Everyone has a unique motivation for giving. Donating to charity is a deeply personal act. Whether you’re spurred on by a cause that’s directly impacted your life, a drive to do right by your community, or to help finance a solution for a worldwide issue, there is no one “right” reason for giving one’s money away.
While there are countless personal purposes for philanthropy, donors generally fall into a particular giving style. These groups are differentiated based on the size of their transferable wealth and the distribution timeline.
There are casual donors who regularly make contributions to a handful of large and local charities when prompted but do not necessarily make a habit of seeking ways to allocate their money. In contrast, there are consistent supporters who almost always impart a reasonable sum to the same causes over a prolonged period. Intentional donors have the broadest scope of all and often have long-term plans to transition a significant amount of wealth to charity, focusing on a few grand objectives over the course of their lifetime.
What Are the Benefits of Giving?
While selflessness and personal fulfillment are their own rewards, charitable contributions may also reduce the tax burden. Unfortunately, volunteers that contribute time cannot take a tax deduction for the cost of labor invested into a charitable cause. However, donating assets to charity provides the ability to benefit from tax deductions.
There is an array of assets that may be given away and officially recognized as donations. This includes cash, long-term capital gain properties such as securities and real estate, and tangible personal property, including art and collectibles.
There are a few things to consider when planning to take ‘write-offs.’ There are limits to the amount taxpayers(s) may deduct each year and it’s based on a percentage of one’s adjusted gross income (AGI). Donors should be cognizant that the available deduction is greater for public charities than private foundations. In the scenario where the value of your donation exceeds the allowable deduction limits in a single year, the deduction may be carried forward for up to 5 years.
These particulars also carry over to the means through which you donate: cash donations allow you to deduct a larger amount than contributions of securities, real estate, and tangible property. However, securities and real estate may be particularly advantageous assets to donate. When an appreciated security is sold, capital gains taxes are owed. But if donated, that same security qualifies for a deduction and avoids the capital gains tax entirely. As such, donors benefit two-fold by gifting securities that have increased in value since their initial purchase.
Donation Strategies
Donors have a wide range of avenues available for transferring funds in service of charity during their lifetime. The most straightforward among them is distributing cash or stock directly. Some charities only accept cash donations and securities transfers are not an option.
Anyone seeking to donate and has an IRA account may consider a Qualified Charitable Distribution (QCD). The QCD allows individuals to donate up to $100,000 a year from an IRA to one or more qualified charities. This method of executing a donation is advantageous for many and especially for those that do not need all or some of their Required Minimum Distribution (RMD) to fund expenses. Unlike regular withdrawals from an IRA, QCDs are excluded from taxable income. Lower taxable income may help reduce the cost of Social Security and Medicare.
Donor Advised Funds (DAF) accounts may be opened at sponsoring organizations such as Fidelity or Schwab Charitable. These funds are relatively easy to set up and maintain. They receive gifts from donors and eventually distribute them to charities. The operative word is “eventually” because these gifts may remain invested within the DAF accounts and potentially grow tax-free for years before you decide which charity(s) will benefit from the donation. With that said, donors may take the charitable deduction upfront as soon as the gift is transferred to the DAF. Appreciated property may be sold within the DAF to avoid capital gains taxes. In many ways, DAFs are like a private family foundation but without the complexities and cost: family members may be included in the charitable giving process and the DAF may be passed down to the next generation.
Private foundations are a viable option for intentional donors engaged in more complex financial planning. These entities operate as 501(c)(3) organization, and the funds are usually provided by a principal family or corporation. The foundation is managed by its own trustees and directors, who allocate the funds to make grants to other charities aligned with their cause(s). Private foundations may also facilitate their own programs, but that is less common with family run organizations. The foundation must spend down or gift at least 5% of its assets each year and pay a nominal excise tax of 1.39% on net investment income.
Like DAFs, private foundations might be a good fit for anyone looking to involve the family with charitable endeavors. Some wealth creators establish private foundations so they can leave a legacy for their descendants to control. However, they require a significant time commitment for directors and trustees in addition to posing sizable administrative burdens like keeping track of grants, filing returns for the entity, as well as maintaining a board of directors and ensuring their salaries. If a private foundation becomes a family affair, it’s essential to make sure that any relatives on staff fulfill their roles in a full-time capacity; not doing so could invite scrutiny and legal trouble. However, these risks and responsibilities also bring a greater degree of control over how the funds are used. Private foundations are not overly costly to start — one can be established for approximately $25,000 — but most experts agree that they should have at least $5 million in assets.
Split-interest vehicles are another option for donors looking to retain some of their gifts for themselves or the next generation. One such arrangement is a Grantor Charitable Lead Trust (CLT), where the grantor is designated as the remainder beneficiary. The trust pays an income stream to a charity or a DAF of the client’s choice. This structure allows clients to take a tax deduction upfront based on the present value of payments promised to charity and ongoing income taxes are paid by the grantor. When the term is over, the grantor receives the remaining assets, which will have likely appreciated through market performance, net of cumulative payments to charity. However, if the grantor dies during the charitable lead term, an additional amount of income will be recaptured on the final income tax return. This may leave the grantor’s heirs vulnerable and on the hook for any outstanding amount.
Conversely, the Non-Grantor Charitable Lead Trust (CLT) is a vehicle where an heir or heirs are designated as the remainder beneficiary. The trust distributes an income stream to a charity, and the heirs, as opposed to the grantor, receive the assets at the end of the term. With the Non-Grantor CLT, the trust pays its own taxes, and the client receives a gift tax deduction based on the present value of the planned payments to charity. This is an option that should be reserved for clients with clearly defined legacy, gifting, and philanthropic objectives.
Another variety of a split-interest vehicle is a Charitable Remainder Trust (CRT). This vehicle pays an income stream back to the client, with the charity of their choice receiving the remaining assets upon the term’s conclusion. The upfront tax deduction is based on calculating the remainder distribution to the charitable beneficiary. Large capital gains liabilities may be spread over time. The client pays the income taxes generated by the assets within the CRT. The major risk of this strategy is that poor asset performance could result in the trust being depleted and its tax-favored status being removed.
Intentional donors looking as far ahead as possible, namely to their passing, have multiple factors to consider. Bequests at death reduce the taxable estate and may be a good strategy to support a charity and avoid paying taxes. Other options include purchasing or transferring a life insurance policy to a charity or designating an organization as a beneficiary of a qualified plan such as an IRA.
Donating and improving the strength of your wealth plan
Choosing where and how to distribute charitable donations is a personal process contingent on one’s circumstances and intentions. Donors should gauge their level of commitment to philanthropic endeavors. Some forms of charitable giving and strategies are far more demanding than others. The benefits of charitable giving may extend well beyond goodwill and allow for considerable income and estate tax benefits.
Although giving season is said to come once a year, it is an ongoing process. Clients should consider discussing their charitable intentions with their wealth manager. Determining the optimal strategy and executing it properly requires aligning philanthropic goals with wealth planning objectives, financial circumstances, and ongoing monitoring.
Disclosures
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