Leveraging DAFs and QCDs for Tax-Effective Donations

When it comes to giving, taxes may not be the first thing on everyone’s mind. You have a cause you want to support, and you make a donation. 

But you should keep in mind that how and when you make your donations can have a significant impact on your taxes.

By being tax-efficient with your donations, you can make your charitable donations go further. 

We’ll examine how donor-advised funds (DAF) and qualified charitable distributions (QCD) work. 

This article was submitted by Jorge Sanchez, M.D.

 

Donor-Advised Funds

A DAF allows you to make an immediate contribution to a fund, receive an immediate tax benefit, and then send the money to charity over several years.

For example, you could put $100,000 of cash in a DAF, giving you a $100,000 charitable deduction for the current year on your tax return. 

When deciding how much you want to put in your DAF, you’ll want to consider the current year’s charitable contribution limit. In 2023, for cash contributions, the limit is 60% of your adjusted gross income (AGI). If you are donating appreciated stock, the limit is 30% of your AGI. 

DAFs do not have any required annual distributions, so you can leave the money in the fund until you have decided which charities you want to support. You do not receive additional deductions when the funds are granted to charities since you have already taken a deduction when funding the DAF.

 

 

Setting up a Donor-Advised Fund

Anyone can create a donor-advised fund. There are no age or income restrictions on establishing the fund.

To set up a DAF, you must do the following: 

1. Find a sponsoring organization. Many public charities sponsor DAFs (even if you intend to give the funds to other organizations). Some companies specialize in setting up DAFs, such as Charityvest, or you can also set up a DAF at a financial institution, such as Schwab, Vanguard, or Fidelity. 
2. Open the account. You must complete some simple paperwork to create the DAF. 
3. Contribute to the fund. Decide whether you want to move cash or securities into the fund.
4. Choose how the funds are invested (if your sponsor allows you to manage the investments).
5. Include the contribution to the fund on your tax return. The donation will appear as cash or non-cash on your return.

Note that you can make multiple contributions to your DAF.

Once the fund is established, tell the sponsoring organization where to send your donations. The donations must be made to a qualified 501(c)(3) charity. 

 

Advantages of Using Donor-Advised Funds

DAFs have several advantages:

• Immediate tax benefit: You’ll receive the total value of your contribution as a tax deduction in the year in which you make it even if you wait years to distribute the funds to charities.
• Investments grow over time: This allows you to make larger contributions in future years as your funds grow.
• Ease of recordkeeping: You only need to track the contributions to your fund. You’ll no longer need to keep every donation receipt for grants from the fund.
• Estate planning: Funds remaining in your DAF can be donated to a specified charity (or charities) on your passing or distributed by your designated beneficiaries
• Funds in a DAF are not considered part of your taxable estate. 

 

Drawbacks of using Donor-Advised Funds

While there are many benefits of DAFs, they are not entirely without drawbacks:

• Lack of control over investments: Depending on your sponsor, you may have little or no control over how your funds are invested. This is generally only an issue with community-based organizations with DAFs.
• Large minimum contribution requirements: The minimum contribution varies depending on your fund sponsor. Minimum brokerage contributions range from $5,000 to $25,000 (or more). Once the fund is established, there are no required future contributions. Companies like Charityvest that specialize in DAFs often have lower minimums and may allow you to establish an account without an initial contribution.
• Limited donation options: Donations must be made to a registered 501(c)(3) charity. Donations cannot result in any personal financial benefit to you (i.e. you can’t create a scholarship where your child is the only one who meets the criteria). 

 

Qualified Charitable Distributions

A QCD directly transfers money from your IRA account to a charity. QCDs can count towards the year’s required minimum distribution (RMD). To be eligible to make a QCD, you must be 70.5. 

The benefit of a QCD is that it is not included in your taxable income. Unlike other charitable giving, it is a coveted above-the-line deduction, typically an itemized, below-the-line deduction.

 

You must be careful since the QCD will be included in 1099-R (taxable retirement income) on your tax form at the end of the year. The QCD needs to be noted separately on your tax return to avoid paying taxes on the QCD.

Since the QCD is not included in your taxable income and reduces your AGI, a QCD can affect several items on your tax return. Consider the following examples.

Example 1: You have an RMD of $80,000 and receive $20,000 of social security income. If you do not make a QCD, your AGI will be $97,000 ($80,000 + $20,000 * 85%). 

But if you decide to contribute $60,000 to a charity through a QCD. Since your income has been reduced by $60,000, which reduces the taxable percentage of your Social Security benefits to 50%. So now your AGI is $ ($80,000 – $60,000 + $20,000 * 50%) = $30,000. 

Example 2: You have an RMD of $200,000, no other income for the year, and $40,000 in medical expenses. You itemize your deductions each year. Since medical expenses must be over 7.5% of your AGI before they are deductible, you can only deduct $15,000 ($40,000 – $200,000 * 7.5%).

If you decide to make a $50,000 QCD, your AGI will be reduced to $150,000 ($200,000 – $50,000). Now you can deduct $28,750 ($40,000 – $150,000 * 7.5%) of medical expenses.

 

How to Make a QCD

To make a QCD, you must be at least 70.5 years old. A QCD must be made from an IRA. 

A QCD must be made directly from your IRA to the charity. Your financial firm will either have you fill out a form or request a QCD online. You’ll provide the amount, name of the charity, and address. 

Your financial institution will either send you a check made out to the charity or mail it to the charity on your behalf.

You’ll need to keep track of your QCDs throughout the year so that you can include the amount on your tax return. As noted above, the QCDs will be included in the taxable amount on your 1099-R at the end of the year, and you’ll need to report the QCD on the return to exclude the amount from your taxable income.

 

Advantages of using QCDs

• Reduce taxable income: A QCD is an above-the-line reduction in your taxable income. They effectively reduce your taxable income whether or not you are itemizing on your tax return.
• Flexibility in selecting the amount: You can change the amount you contribute each year without making any decisions in advance. 

 

Drawbacks of using QCDs

• Age restriction: QCDs are only available to taxpayers over age 70.5. 
• Limited amount: You are limited to $100,000 each year of QCDs. A married couple filing jointly can make $100,000, but the QCDs must be made from each spouse’s IRA.
• Restriction on Donations: QCDs cannot be made to a DAF, even if a DAF is run by 501(c)(3).

 

Comparing Donor-Advised Funds and Qualified Charitable Distributions

When it comes to eligibility, DAFs win since anyone can contribute to a DAF at any age. The age restrictions on QCDs mean they are not an option for younger taxpayers.

 

DAFs give donors more control over the timing of donations. Donations from a DAF can be made at any time; there is no minimum each year. QCDs must be made each year to be deductible, and each person is limited to $100,000/year.

QCDs are more effective when minimizing taxes since they are an above-the-line deduction and lower your AGI. DAFs are appropriate when you want to batch your charitable deductions (especially if you take the standard deduction in some years). 

 

Secure Act 2.0 

The Secure Act 2.0 changed the QCD rules. 

The first change is that the $100,000 limit for QCDs will be indexed for inflation each year starting in 2024. The IRS will publish new limits each year. 

The other change is to allow a one-time use of a QCD to fund a split-interest gift. A split-interest gift allows you to donate to a qualifying trust in which you still receive income from the assets while you are alive, but the assets are donated to charity upon your death. The split-interest gift is irrevocable. 

 

Final Thoughts on Donor-Advised Funds versus Qualified Charitable Deductions

A strategic approach to charitable giving can help you minimize your taxes, maximizing your giving potential. You’ll need to consider your age, assets, the amount you want to donate, and tax brackets. These factors will determine whether a DAF or QCD is appropriate for you. 

DAFs provide immediate tax benefits for long-term charitable giving plans, while QCDs provide an immediate above-the-line deduction.

The key is considering both options as tools and part of your long-term giving strategy.