This year, several of our clients have unexpectedly found they will have significantly more income than normal. From becoming partner to a surprising success with a non-doctor spouse’s startup business to an unplanned buyout of a practice, they have a very happy problem. The problem is, of course, they’ll have significantly more taxes.

Fortunately, tax rates fell with the Jobs Cuts and Tax Act of 2017 (JCTA), but it’s not much comfort for a high-income family to hear that, while they will probably owe ~$300k in taxes this year, it would have been $325k if not for JCTA. $300k is a sickening amount of taxes to pay for a year of hard work.

Fortunately, these clients are charitably inclined. Now that they will have a sizable uptick in cash flow, they have the opportunity to do something significant that also helps reduce their tax burden. The Donor Advised Fund, or DAF, will allow them to do that.

Charitable donations are one of the few itemized deductions that were actually increased in the last tax bill. But because the standard deduction is now $24,400 (2019) for married couples, many families still will not be able to itemize. You can take exquisite advantage of itemized deduction timing, however, with a DAF.

What is a DAF?

A DAF is an account that you open with a qualified charitable organization, donate money or property to, and use for future donations. DAFs have been employed by the uber-wealthy for decades but they are just beginning to go mainstream for middle America’s high earners.

You get a tax deduction for any year you make gifts to your DAF. Typically, the funds in the DAF are invested for future growth. You can make donations from your DAF any time you want to support a qualified charity.

Think of a DAF as an investment account you earmark solely for charity. You can deduct cash contributions to the DAF of up to 60% of your AGI (Adjusted Gross Income), allowing you to control the taxes you pay in any one year. In the meantime, your investments grow and you have more to donate in the future. (Note that, before JCTA, the contribution limitation was 50%.)

Imagine compressing all the tax-deductible donations you’ll make after retirement (when you’re in a much lower bracket) into the present, while you’re at peak earnings. You’ll get to take advantage of the new, higher standard deduction in retirement and you’ll get to reduce top-bracket income today. This is especially good news if you’re working somewhere such as NYC and your marginal tax bracket is 48% (yes, that is the real number for some of our clients!)

If you’re at top earnings and planning to cut back to part-time or retire in the near future, you really should think about a DAF today. Don’t waste your future donation deductions when you’re in a lower tax bracket – front-load them now when you’re paying top rates.

Super-DAF

Last week, I was meeting with clients who have a taxable account filled with individual stocks. The account now has over $200k of unrealized LTCG (Long-Term Capital Gains) and desperately needs rebalancing. We’ve been delicately weighing the tax liability for rebalancing (about $60k) against the risk of holding individual stocks and their exposure to a greater-than-normal drop in market declines (resulting in reduced long-term returns).

This year has been a very successful one, business-wise, which means they are facing a mid-six-figure tax liability for 2018. Because this couple has a deep commitment to helping others and is also very involved in their church, they decided a DAF is a perfect solution.

We are in the process of setting up their DAF. They will contribute their appreciated stock portfolio, get a tax deduction for the full value, and rebalance after they have made the donation and won’t owe taxes on the sale. They’ll get a sizeable income tax deduction for the donation and can repeat in the future as needed. Future charitable contributions will be from the DAF, rather than their bank account.

The rules for appreciated property (Super-DAFs)

Gifts of appreciated property, such as securities, are limited to a deduction equaling 30% of AGI and the property must have been held for over 1 year (i.e. LTCG property). Your gift must be made to a “60% charity” – one that the IRS allows a deduction of up to 60% of AGI for cash donations.

Some examples of 60% charities are churches, educational organizations, and hospitals and medical research facilities. Fortunately, if you gift property valued at more than 30% of your AGI, any remaining deduction can be carried forward for up to 5 years.

Gifting appreciated real estate is another excellent way to get a sizeable tax deduction and, while it is more complex, this can also be handled through a DAF. (I would not recommend gifting your residence, because you will be wasting the $250k per spouse exemption from LTCG taxes.) For example, a piece of appreciated land can be gifted to a DAF, sold, and the proceeds invested for future donations.

As you can see, taxation is a critical component when setting up and funding a DAF. Be sure to coordinate with a CPA and/or fee-only financial planner who has experience with high-level tax planning.

Using a DAF for Roth conversions

We recommend clients target a proportion of investments at retirement of 1/3 in Roth IRAs and HSAs, 1/3 in pre-tax accounts (401k’s/403b’s, etc.) and 1/3 in taxable accounts. Our clients tend to be high earners and high savers. We don’t want them to get to retirement and be in an even higher tax bracket because of high RMDs and other needs from taxable IRAs. Because many of our physician families are in the first 1/3 of their careers, this gives us a good measuring stick to follow.

But the problem is more significant for those who are further along in their careers and have a significant tilt toward pre-tax retirement accounts. DAF contributions can mitigate the taxes on Roth conversions. In particular, a significant DAF contribution would offset a Roth conversion or you could fill a lower tax bracket with your conversion and make a DAF contribution to equal any conversion income that is shifted to a higher tax bracket.

Other DAF benefits

DAF’s have some appealing non-financial benefits:

• You can more easily remain anonymous when making gifts because the DAF doesn’t have to reveal your identity.
• You can make it a family project. Use your DAF to teach your children about your values by letting them help choose your annual donation projects.
• It can facilitate estate planning. By leaving assets to your DAF, your heirs will continue your legacy after your death without the temptation of using the funds personally.

Choosing your DAF provider

It is important to choose a DAF provider that is a good fit for your intentions. DAFs are maintained by local charities and community foundations for those who want to keep gifts local. If you are funding a “super DAF” or donate internationally, you’re probably going to need to look to an organization with more sophisticated resources. (Note that international organizations must be qualified as a 501(c)3 in the US to qualify to accept DAF contributions.)

If you’re interested in setting up your own DAF and would like to know more, Ben has tips for how to get started in this month’s vlog.

How to set up a DAF