14 August 2022

How to build a charitable giving war chest – Part 2

By Adrian Colarusso, CFA, CFP®

August 14, 2022

In part 1, I wrote about the increasing importance of stock-based compensation in today’s job market. Stock compensation can be tricky to navigate, and I encourage you to work with an advisor early to help with the time-sensitive and complicated decisions that it involves.

In part 2 today, I’ll pull the thread further on this hypothetical wealth journey. Let’s say stock compensation has led to a highly appreciated asset, a looming tax bill, and the wealth capacity for meaningful charitable giving. Depending on your situation, a Donor Advised Fund could be a much more tax-efficient and impactful way to give compared to cash out of pocket.

What causes do you care about most? Think local, national and global. What is your favorite non-profit and why? Let know in the comments (i.e. reply to this email!)

You don’t necessarily have to meet all three of the conditions below for a DAF to make sense. But if you meet all three (and you care about charitable giving, of course), then it might be a no-brainer.

Three conditions to get the most from a Donor Advised Fund (DAF):

1)    You are in a high tax bracket

Whatever bracket you are in, your taxes are too high. But if you plan ahead, you might contribute to a DAF in a year when your income is relatively high for you.

In our situation, we knew I was leaving my corporate job and we’d be slipping down a couple brackets while I build my business. We made a DAF contribution in a high-income year for the most potent tax benefit. This pulled forward and stockpiled our charitable giving from future years. Now we’re in a lower tax bracket with less disposable income for charity, but we are as supportive as ever of our favorite non-profits.

Another way to look at it – let’s say your income for the year will peskily creep a few thousand dollars into the next highest tax bracket. You may want to calibrate the size of your DAF contribution to get you just back into the next bracket down.

2)    You itemize deductions on your tax return

This one is key. When you file taxes, you can take the standard deduction ($25,900 for married filing jointly, MFJ) or itemize your deductions, where you would list out charitable contributions. If you take the standard deduction because it exceeds the sum of your itemized deductions, charitable donations effectively provide no tax benefit.

The most common situation where you will likely itemize deductions (assuming MFJ):

  • You pay at least $10,000 in state and local taxes (“SALT”) on income and property.*
  • You pay at least $15,900 in mortgage interest. This is roughly the first year’s interest on a $300,000 loan at 5.25%. Note that you pay more interest in the earlier years of a mortgage compared to later years. So if you are close to this amount, you may slip back into taking the standard deduction in future years, and you’ll want to make your DAF contribution before that happens.

If you itemize deductions, the current value of any asset you contribute to a DAF (or donate directly to charity in cash, for that matter) can decrease your taxable income dollar for dollar.

*This limit was imposed in the 2017 tax reform. It’s a political lightening rod. If Congress raises the limit, which is in discussion, it will be more likely that taxpayers in high-tax states will itemize their deductions, and therefore find it beneficial to contribute to a Donor Advised Fund. So, if you don’t itemize this year, keep an eye on this potential evolution in the tax code!

3)    You own a highly appreciated asset

Stock compensation isn’t the only way to find yourself with this champagne problem, but that’s what I predict will be most common among my clients in the years to come.

In our situation, we had some stock ETFs in our taxable brokerage account that had appreciated considerably during the bull market.

The larger the gain on the asset, the better. This is the tax liability you are effectively wiping away since non-profits are not subject to it.

Other examples I’ve seen of highly appreciated assets:

  • Grandma gave you a bunch of Disney shares as a Bar Mitzvah gift in 2002 and now it’s up almost 7-fold.
  • It’s time to sell the family business to private equity, and the cost basis is close to zero.
  • You founded a company and it’s about to IPO.
  • You bought Bitcoin or another cryptocurrency early

Again, you don’t NEED an appreciated asset to contribute to a DAF – you can contribute cash and deduct it from your income – but you shouldn’t use cash if you have an appreciated asset to contribute instead.

Let’s look at a simplified example:

Chris and Amanda estimate they will have $382,000 in combined income for 2022, placing them in the middle of the 32% federal income tax bracket.

In 2021 they bought a home, and in this first full year of mortgage payments, their mortgage interest will total $17,000.

They easily meet the $10,000 state income tax deduction limit as homeowners in New York. Their local property taxes alone exceed this amount.

Chris has been sitting on Restricted Stock Units (RSUs) from his company, which have since doubled in value to be worth $100,000 since they vested over a year ago.

The couple decides to place $15,000 worth of Chris’s company shares into a Donor Advised Fund and itemize that deduction. On their tax return, they will subtract $42,000 ($10k + $17k +$15k) from their gross income to arrive at their taxable income of $340,000, placing them just below the ceiling of the next bracket down. On a post-tax basis, that $15,000 of generosity will only cost them $10,200. This doesn’t account for potential savings on state income taxes, which I’m ignoring for simplicity.

Within their DAF, they are able to sell the stock without incurring a 15% capital gains tax on the $7,500 in appreciation. This is $1,125 that would go to charity instead of Uncle Sam if they had sold the stock outside of the DAF and then donated the after-tax cash.

Chris and Amanda re-invest the $15,000 into a diversified portfolio that shouldn’t fluctuate as much as a single stock, but still has the potential to grow. They can then take their time to deploy the money to the causes they care about.

Target Rock does not offer tax advice. This is a hypothetical example for illustrative purposes only, with many important details omitted for clarity. Talk to a CPA and an advisor who can consider your unique situation before implementing any tax or investment strategy.

Any questions? Please feel free to reach out.