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3 Reasons to Set Up a Donor-Advised Fund to Maximize Your Charitable Tax Deductions

Using donor-advised funds is a more advanced tax strategy that has gotten more popular recently with the introduction of the Tax Cuts and Jobs Act (TCJA) in February 2020. The TCJA nearly doubled the amount of the standard deduction, which makes it less advantageous to itemize deductions such as charitable contributions. For people with a lot of charitable contributions, donor-advised funds are one option to still get a deduction for charitable contributions.

What is a donor-advised fund?

A donor-advised fund (DAF) is a registered 501(c)(3) charitable organization that accepts contributions and generally funds other charitable organizations. While the concept of a donor-advised fund has been around for nearly 100 years, they were typically only used by the ultra-wealthy. And while it is true that donor-advised funds are still not going to be useful for the vast majority of people, recent tax law changes have made their use more prevalent.

You can set up a donor-advised fund with most brokerages, including Fidelity, Vanguard, and Bank of America. You can donate cash, securities, or other types of assets to the DAF. The exact list of assets eligible for donation depends on the brokerage. After you have contributed, you can then make charitable contributions from the balance of your account.

You can maximize your charitable tax deductions in one year

One common reason that people set up donor-advised funds is to maximize their charitable tax deductions in a particular tax year. To show why this can be beneficial, I’ll use an example:

Our example family files their taxes married filing jointly and has regular charitable contributions of $20,000 per year. The standard deduction in 2020 for married filing jointly is $24,800. Because their amount of charitable deductions is less than the standard deduction, they may not see any tax benefit from their charitable contributions (depending on their amount of other itemized deductions). In 2021 they again plan to contribute $20,000 to charitable organizations and again are unlikely to see any tax benefit from doing so.

Now consider this same family now decides to set up a donor-advised fund in 2020. They have extra money sitting around in low-interest savings or checking account or in a taxable investment account. So they set up a donor-advised fund in 2020 and fund it with $40,000 in cash, stocks, or other assets. They are eligible to take the full $40,000 as an itemized deduction, even if they only use $20,000 to donate to the charity of their choice. Then in 2021, they can donate the remaining $20,000 to their preferred charity. They will not be able to deduct any charitable contributions in 2021 but can instead take the raised standard deduction amount.

You may be able to deduct the full value of stocks or other investments

Another reason you might want to set up a donor-advised fund is that you may be able to deduct the full value of stocks or other investments. Again, I’ll use an example to help illustrate the point.

Let’s say that you have shares that you purchased for $20,000 that are now worth $50,000. Many charities, especially smaller organizations, are not set up to accept donations of stocks or other investments. So if you want to donate that $50,000 to charity, you may have to liquidate your shares. This will mean that you will have to pay tax on the proceeds.

With a donor-advised fund, you can donate the shares to your fund and deduct the full fair market value of your shares. Then the fund can make the contribution to the charity of your choice.

Donate a wide range of assets

Another benefit to setting up a donor-advised fund is the ability to donate a wide range of different classes of assets. As we mentioned earlier, many charities are not set up in such a way to be able to accept non-cash donations. While the exact list of assets that a donor-advised fund can accept varies by the firm running the fund, it generally will include more types of assets than a typical charity.

Why you might not want to set up a donor-advised fund

While there are plenty of advantages to setting up a donor-advised fund, there are a few things that you might want to watch out for.

  • It’s definitely more complicated than just making charitable contributions on your own. You may find that the tax savings are not worth the extra hassle.
  • On top of the added layer of complexity, most firms with DAFs charge administrative fees that can cut into your rate of return.
  • You may be limited on the charities that you can donate to. Each donor-advised fund typically will have a list of eligible charities. So you may find that a charity that you want to donate to is not available.
  • You also lose control over the funds that you donate – the donation to the fund is irrevocable, meaning once you’ve donated to the fund you cannot get the donation back. While most advisors state that they will donate the money as you direct, they are not legally required to do so.
  • The money in a DAF is invested, so it may lose value. That means that the amount you were hoping to donate may be less than you were anticipating. You also typically have a limited range of investments available for your investment, and those funds also often come with fees.

It’s also important to keep in mind, the annual income tax deduction limits for gifts to donor-advised funds, are 60% of Adjusted Gross Income for contributions of cash, 30% of AGI for contributions of property that would qualify for capital gains tax treatment; 50% of AGI for blended contributions of cash and non-cash assets.

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Most-Overlooked Tax Breaks for the Newly Divorced

The pandemic is creating a lot of extra stress in some households. Money problems, no social life outside the home, fussing with kids who are learning remotely, and generally being cooped up with each other for months can spell disaster for certain married couples. That’s why divorce rates are expected to rise sharply in 2021.

So, if you’re calling it quits on your marriage, add filing taxes after divorce to the long list of headaches you need to deal with. For starters, if you haven’t already done so, you need to file a new W-4 form with your employer to adjust the amount withheld from your paycheck. But that’s not all…you might also be facing alimony payments, child custody arrangements, home sales and other divorce-related issues that can affect your taxes.

The last thing you need after a divorce is another problem to deal with. So, to reduce your stress, here are 7 tips to make your return to single life a little more tax-friendly.

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Filing Status

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Your marital status as of December 31 controls your filing status. So, if you split up but were not yet officially divorced before the end of last year, you can still file a joint return (which is likely to save you money) or choose the married-filing-separately status for your 2020 tax return. You can also file as head of household (and get the benefit of a bigger standard deduction and gentler tax brackets) if you lived apart from your spouse for the last six months of the year, file separate returns, had a dependent living with you for more than half of the year, and paid more than half of the upkeep for your home.

Once you’re divorced, you can file as a head of household (if you have a dependent living with you for more than half of the year and you pay for more than half of the upkeep for your home) or as a single taxpayer.

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Alimony Payments

picture of blocks spelling out "alimony"picture of blocks spelling out "alimony"

You can deduct alimony you pay to an ex-spouse if the divorce agreement was in place before the end of 2018. Otherwise, it’s not deductible (or taxable to the recipient). You also lose the deduction if the agreement is changed after 2018 to exclude the alimony from your former spouse’s income.

To qualify as deductible alimony, the cash-only payments must be spelled out in your divorce agreement. You’re required to report the Social Security number of your ex-spouse, too, so the IRS can make sure he or she reports the alimony as taxable income.

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Credits for Children

picture of father and son togetherpicture of father and son together

As a general rule, only the custodial parent (the one the kids live with most of the year) can claim the child tax credit or credit for other dependents for a divorced couple’s qualifying children. The child tax credit is worth $2,000 per child (up to $1,400 is refundable), while the credit for other dependents can be as high as $500 for each qualifying dependent (e.g., children over 16 years of age).

But it’s perfectly legal for the noncustodial parent to claim one of these credits for a son or daughter if the other parent signs a waiver agreeing not to claim an exemption for the same child on his or her return (which means the custodial parent can’t claim the credit). Form 8332 must accompany the noncustodial parent’s return each year he or she claims the credits for the child. This could make financial sense if the noncustodial parent is in a higher tax bracket.

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Medical Expenses of Children

picture of a mother and daughter in a doctor's officepicture of a mother and daughter in a doctor's office

If you continue to pay a child’s medical bills after the divorce, you can include those costs in your medical-expense deductions even if your ex-spouse has custody of the child. For 2019, medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income, but the child’s bills you pay could push you over the 7.5% threshold.

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Asset Transfers

picture of man dividing blocks representing assetspicture of man dividing blocks representing assets

When a divorce settlement shifts property from one spouse to another, the recipient doesn’t pay tax on that transfer. That’s the good news.

But it’s important to remember that the property’s tax basis shifts as well. Thus, if you get property from your ex in the divorce and later sell it, you will pay capital gains tax on all the appreciation before as well as after the transfer. That’s why, when you’re splitting up property, you need to consider the tax basis as well as the value of the property. A $100,000 bank account is worth more to you than a $100,000 stock portfolio that has a basis of $50,000. There’s no tax on the former, but when you sell the stock, you will owe tax on the $50,000 profit.

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Home Sales

picture of for sale sign in someone's lawnpicture of for sale sign in someone's lawn

If, as part of your divorce, you and your ex decide to sell your home, the timing can have tax consequences. Normally, the law allows you to avoid tax on the first $250,000 of gain on the sale of your primary home if you have owned the home and lived there at least two years out of the last five. Married couples filing jointly can exclude up to $500,000. For sales after a divorce, if the two-year ownership-and-use tests are met, you and your ex can each exclude up to $250,000 of gain on your individual returns.

If the two-year tests haven’t been met, sales after a divorce can still qualify for a reduced exclusion. The limit on tax-free profit in this case depends on the portion of the two-year period for which the home was owned and used. If, for example, it was one year instead of two, you each can exclude $125,000 of gain. What happens if you receive the house in the divorce settlement and sell it several years later? Then you’re stuck with the $250,000 maximum.

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IRA Contribution

picture of piggy bank sitting on blocks spelling out I-R-Apicture of piggy bank sitting on blocks spelling out I-R-A

Generally, a taxpayer must have earned income from a job or self-employment to qualify to contribute to an IRA. However, there’s an exception for some divorced people.

Taxable alimony you receive counts as compensation for the purposes of making IRA contributions. For 2021, you can contribute up to $6,000 to a traditional IRA or a Roth IRA, or a combination of the two. If you’re at least 50 years old, you can contribute an additional $1,000 for the year.


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