[Editor's Note: The following first appeared on WCI Network partner, Physician on FIRE. PoF has actually made a bit of name for himself in the blogosphere for writing about charitable giving and donor advised funds in particular. As we come into “giving season” I think it's highly appropriate to bring one of these excellent posts over to WCI. I've somehow acquired the reputation of being anti-DAF. I'm not really, I'm just anti-putting money in a DAF for decades without actually distributing any of it to charities. Don't tell PoF, but I think I'll actually give (immediately) via a DAF in 2019. At any rate, enjoy the post. ]
No, not the candy bar.
In a related post, I shared how I woke up $100,000 poorer on my 41st birthday. This act of portfolio sabotage was self-inflicted; I greeted the news with a smile. The hundred grand is no longer mine, but I now have the opportunity now to use it to do some good in this world that my family and I live in.
I’ve discussed why I choose to donate. Today’s post will describe how I use a donor-advised fund to get the most for my donated dollars.
The easiest way to donate to charity is to simply write a check for cash to your favorite charity. As long as you are giving to a bona fide 501(c)(3) charity (there are over a million in this nation), and you receive a receipt, you can include the donation in your itemized deductions to reduce your income tax. This assumes your itemized deductions exceed the standard deduction.
The Easiest Way is Not the Best Way
How can you donate more to charity at a lower cost to you? By donating appreciated assets. That is, stocks or bonds or mutual funds containing them that are now worth more than you paid.
While you may be able to arrange for a donation of your assets directly to a charitable organization, not every organization would know how to handle the transfer. Small, local charities, the kind I like to give to, could be particularly thorny. This is where the Donor Advised Fund (DAF) comes in.
The DAF accepts your donation and keeps your donated dollars in an account that you control. You get a tax deduction in the year you donate, and you can request grants to charities of your choosing at any time in the future.
Some of the larger brokerage companies, including Vanguard, Fidelity, T. Rowe Price, and Schwab have corresponding DAFs, which can easily accept your donated funds, and have easy-to-navigate online interfaces allowing you to dish out the money when you decide it’s time to give.
I actually have a DAF with both Vanguard and Fidelity, and used to have one with T. Rowe Price, but I moved the funds when I made the switch to Vanguard with my overall investment portfolio.
I like the Fidelity fund for the lower minimum grants compared to Vanguard ($50 vs. $500). It also has a lower minimum to get started ($5,000 vs. $25,000). But I use the Vanguard fund as well, largely for the ease of transfer of my mutual funds, which happens literally overnight, as I will detail below.
Goodbye, Capital Gains
The reason it’s more advantageous to give appreciated assets than cash is the elimination of capital gains taxes. There aren’t that many ways to obviate capital gains — I outline the best ways here — and some are almost never advisable, like death for instance. I would advise against death as a tax avoidance strategy 100% of the time.
When you donate appreciated assets, neither you nor the receiving charitable organization owe capital gains taxes. Donating assets can be a particularly powerful strategy if you have large gains, especially if it’s a fund that may not be well suited for your portfolio, like the ones discovered by this random guy, who also happens to be a physician.
I opened my first DAF in 2013 when I realized my taxable account was a pretty random collection of actively managed funds and index funds with unnecessarily high fees that didn’t make much sense in my portfolio. I had been investing early and often, but not especially well.
The markets had been soaring since I started buying mutual funds in 2009. I had substantial gains, was living in a high tax bracket, and was feeling generous. In an effort to simplify, I sold some of the lower performers, donated some of the higher performers, and did more of the same the next calendar year.
My current collection of funds were all purchased within the last few years, so the gains aren’t huge. Still, they’re there for the giving. In order to decide which funds and lots to give, I needed to take a close look at my mutual fund holdings.
I have four funds in two general categories (U.S. Stock and International Stock) in my Vanguard taxable brokerage account. If I were sticking with a simple three fund portfolio, I would have two funds here, but I like to take advantage of tax loss harvesting, so I’ve ended up with partner funds in the account.
Here’s a look at the gains in funds I’m holding. You’ll notice it’s all green. Any red (tax loss) has been harvested.
I’ve got $151,367.52 in gains, most of them short-term. While I would love to get rid of the gains only, it doesn’t work that way. You have to give away specific lots.
I created a spreadsheet from the information Vanguard supplies to assist in my donation decision-making. I added the “% Return” column, using a simple formula. All the rest of the data came straight from Vanguard. I have “Specific ID” chosen as my cost basis method, which is important for both tax loss harvesting and donation purposes. The overall average gain of my lots in the taxable account is 15.7%. It would behoove me to part with the lots with above-average gains. The international funds have gains below the threshold, so I’ll hang onto those. The US stock funds (VFIAX = S&P 500 index, VTSAX = total stock market index) had better gains, and the funds held the longest had the largest gains. I chose enough of them to add up to $100,000 and pulled the trigger.
You can choose which funds to donate online, but unlike when you sell or exchange, Vanguard’s site will not allow you to select specific lots. Grrrrr… It can be done with a phone call or letter of instruction, but this is the 21st century, darn it. I shouldn’t have to send snail mail or talk to anyone, for any reason, ever.
This hiccup was inconsequential, as their preferred method (FIFO) of donating the lots held longest corresponded with the highest returns. These are the lots I want to part with to discard the most potential capital gains. Altogether, the $100,000 I donated had a cost basis of about $78,000, for a $22,000 long-term capital gain.
Calculating the Tax Savings
If I would have sold the funds and donated cash before donating the $100,000, I would owe capital gains taxes on the $22,000. How much would that cost me?
Since I had held all of these lots for more than a year, they would all be taxed at the long-term capital gains (LTCG) rate. So, 15% of $22,000 = $3,300, right?
Wrong. Add in my state income tax of 9.85%, the NIIT / ACA surtax of 3.8% to arrive at my LTCG tax rate of 28.65%. If I had a higher income — enough to put me in the 20% federal capital gains tax bracket — it would be 33.65%. In California, the LTCG tax can approach 37%. So, donating appreciated funds rather than selling and donating cash saved me $22,000 x 28.65% = $6,300.
Then, of course, there is the benefit of deducting $100,000 from my taxable income. It can get pretty complicated to calculate this one, and everyone’s situation will be different, but factoring in medicare (FICA), federal income, and state income tax reduction at my marginal tax rate, I can expect a tax refund in April of at least $42,000 based on this one big donation.
While the $6,300 is only a relative gain compared to selling funds now (which I would never do), the $42,000 tax refund is very much real, and it should hit my account within days of filing my taxes this spring. In other words, when the dust settles, this $100,000 donation cost me $58,000, and reduced my remaining cost basis in my taxable account by $22,000.
Donate Now, Give Later
The benefit of growing the fund while working is obvious. Our tax code makes it much more beneficial to give when your income is high. If I were to wait until the paychecks stop coming to build up our DAF, the tax breaks would be much smaller.
It makes good sense to give from your surplus, and the surplus will change before and after retirement.
Right now, my surplus is money. I have financial independence, and I’ve already worked one more year since realizing it. Soon, despite the financial setback I instigated, I will have my financial freedom.
In a few years, I don’t anticipate spending nearly as much time, if any, in clinical medicine. Then, my surplus will be time. If I’ve satisfied my family and personal needs for my time, I can afford to be more generous with my remaining free time, which is something I don’t do a whole lot of right now.
As I mentioned previously, I don’t plan to give out $100,000 to my favorite charities right away. Much like I don’t spend all of my paycheck when it hits the bank account, I won’t give away all the new DAF money right away, either. Rather, I’ll use it to give an extra $5,000 or so this year.
I have a goal of having a DAF equal to 10% of my investments before retiring early. After the latest donation, the sum of my Fidelity and Vanguard DAFs have more than doubled to between 8% and 9% of my investments. One smaller lump sum next year, which is potentially my last full year working full time, ought to get me there.
Treat the DAF Like Your Nest Egg
A $250,000 DAF will allow me to comfortably give away at least $10,000 a year indefinitely using a 4% safe withdrawal rule as a guide. I won’t receive any further tax deduction for the annual gifts; I’ve already taken them at the best time, when my income and deduction potential are at a maximum.
The money is invested according to my specification. I keep an aggressive allocation because this is money I can afford to lose but would like to see grow to its fullest potential. Using Vanguard’s Total Equity allocation, I am invested in an automatically rebalanced portfolio of 55% S&P 500, 15% Extended Market, and 30% International Stock index funds, with an expense ratio of 0.08%.
In addition to the expense ratio, there is a 0.6% account fee. This closely approximates the tax drag on my taxable account as a result of about a 30% LTCG gains tax on a 2% dividend. Fidelity and Schwab have similar fees.
There you have it. The best way to donate a hundred grand. You don’t need nearly that much to get started, though. For $5,000, you can get started with Fidelity Charitable.
There’s no need to wait until you’re close to retirement to start benefiting from a donor-advised fund. There is some advantage to giving the most during your highest salaried years, so if you are on a steep upward trajectory, it might be wise to wait a bit. On the other hand, there’s a penalty to waiting until after your peak earning years to fund one.
For more information on Donor Advised Funds, see my posts on the topic: