With President Joe Biden’s proposed changes to tax law, many investors wonder how to adjust their portfolios to minimize the impact. In addition to possible increases in income tax rates and the maximum tax on capital gains, one proposal in the table includes limiting the increase in the base for inherited assets. Under current tax law, the cost base for inherited assets generally increases after the death of the original owner, which means that the beneficiary only pays taxes on gains in excess of the increased value. Biden has suggested limiting this benefit to $ 1 million per person or $ 2 million per couple.
In addition, the tax changes made in 2018 make it more difficult to claim a charitable allowance. With most investors now using the standard deduction instead of line items, it can be beneficial to “pool” charitable donations by making a larger donation in a single year, which could allow you to cross the line item deduction threshold rather than making smaller annual donations may not be tax deductible. Donor Advised Funds can facilitate this strategy because donors can make a larger contribution to a Donor Advised Fund in a single year and make the individual withdrawal upfront, but still make charitable contributions over time.
For both of these reasons, donor-advised funds are worth considering. In this article, I’ll cover some of the basics of donor-recommended funds, as well as how you can decide whether they make sense for you.
The basics of donor advised funds
A donor advised fund is a tool that allows investors to donate directly to a charitable fund while maintaining control of the assets. Fund Administrators Advised by Donors are not-for-profit organizations that qualify as Section 501 (c) (3) organizations. This means donors can benefit from an instant tax deduction when adding cash or other assets to the fund. Although contributions are irrevocable (meaning you won’t be able to withdraw donations if you change your mind or need extra money), the donor remains in control of how the assets are invested and how much is donated to various charities over time should. Remaining assets benefit from tax-free growth as long as the account remains funded.
Donor-advised funds have become increasingly popular in recent years. The National Philanthropic Trust estimates these funds had net worth around $ 142 billion at the end of 2019. There are several main types of donor advised funds: those managed directly by a particular charity; those administered by a community foundation or religious organization (such as the Jewish United Fund or Catholic charities); and those managed by an organization affiliated with a financial institution such as Fidelity, Schwab, or Vanguard. In this article, I’ll focus on the third category, but the other two types are broadly similar.
The main benefit of donor advised funds is the ability to have an instant tax deduction on the amount deposited. Donors can deduct up to 60% of the adjusted gross income. (Individuals can currently deduct up to 100% of Adjusted Gross Income in 2021 for donations made directly to qualified nonprofits under the Consolidated Funds Act. However, this is a temporary limit and does not apply to funds recommended by donors.)
Donors can also bring in a wide range of valued assets, including stocks, bonds, mutual funds, privately held business interests, restricted stocks, and even bitcoin and other cryptocurrencies. Donors who contribute securities or other assets can deduct up to 30% of adjusted gross income. The in-kind tax deduction can be particularly useful for highly valued assets as it allows investors to remove those assets from their taxable portfolios (thereby improving diversification and reducing security risk) without the inherent capital gain associated with them To accept tax damage. The donor advised fund will handle the sale of the valued asset, but no realized capital gain is to be reported.
Donors to a donor-advised fund also retain full control over when and where to donate to charity. Account holders can donate all at once or over time and to a single charity or a variety of nonprofits. The main requirement is that donations go to a qualified non-profit organization. Each donor-advised fund sets its own minimum amount for grants to charities. Fidelity and Schwab currently have a minimum of $ 50 while Vanguard requires a minimum grant of $ 500.
The donors also retain control over how the remaining assets are invested. Investors can typically choose from several preset investment options with varying levels of risk, ranging from conservative, bond-intensive portfolios to more aggressive, equity-oriented portfolios. Investors can either choose one of these preset portfolios or create their own portfolios using a longer list of individual asset class options. It is also possible to allocate some funds for upcoming donations in highly liquid securities (e.g. a money market fund) while investing other assets for longer term growth.
Despite their benefits, donor-advised funds are not the right choice for everyone. Although Schwab and Fidelity now allow investors to set up a donor-advised fund with any dollar amount, Vanguard Charitable currently requires an initial contribution of $ 25,000. Funds advised by donors also incur annual administrative costs. Fidelity, Vanguard, and Schwab charge a 0.6% administration fee for accounts with up to $ 500,000. All three have tiered cost structures so that accounts with more than $ 500,000 in credit incur lower percentage fees.
These fees are in addition to the fees for the underlying investments (operating costs for mutual and exchange-traded funds or trading commissions for individual stocks and bonds). All of these fees come from the amount donated, which makes donor-recommended funds less cost-effective than donating directly to a charity.
Charitable grants are also subject to a minimum donation amount. Schwab and Fidelity each require a minimum of $ 50, while Vanguard requires a minimum of $ 500 for each grant. The account administrator must also approve each grant before the money is paid out. Investors looking to donate smaller amounts of money may find it easier and cheaper to donate directly, especially if they often donate to the same charities every year.
Some wealthier families and individuals may prefer to set up a private foundation to make charitable donations. A private foundation is an independent legal entity that has its own statutes, statutes and a board of directors or a board of trustees. In contrast to donor-advised funds, foundations have to file annual tax returns and distribute at least 5% of the average assets of the previous year each year, but they also have additional flexibility in granting grants. For example, a private foundation may provide scholarships and grants directly to individuals, provide direct grants to families or individuals facing difficulties and emergencies, and run their own charity programs.
Compare the options
The following table shows how three of the largest donor-recommended funds stack up. Fidelity and Schwab are accessible to most investors as they do not require a minimum amount for initial or additional contributions. However, Vanguard offers lower management fees for accounts with higher balance.
All three donor-advised funds offer a range of investment options, including both diversified pools of assets with exposure to a range of asset classes and single asset pools that can be used as building blocks for donors to build their own portfolios. Fidelity and Schwab offer both in-house funds and offers from third-party providers. Vanguard’s lineup consists almost entirely of in-house funds, but almost all investment options are index funds with extremely low expense ratios. In my next three articles, I’ll dig deeper into the underlying investment options for the top three financier-advised funds.