How to optimize your taxes as a donor in the US: donate appreciated securities, make a donor-advised fund, and bunch your donationspost by sam_brenner · 2022-04-30T10:19:40.987Z · EA · GW · 5 comments
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Summary The three parts in brief 1. Donating appreciated securities 2. Using a donor-advised fund or Betterment 3. Bunching The three parts in detail 1. Donating appreciated securities The benefit The caveats A worked example Some sources to substantiate my claim that donating appreciated securities means you avoid capital gains taxes on them How to do it and caveats My recommendations 2. Using a donor-advised fund or Betterment What it is How it works Reasons you might not want to use it How to set up and use a donor-advised fund 3. Bunching A motivating example Estimated benefits Calculate your estimated taxes Quick intro to tax terminology None 5 comments
I think that every EA who's planning to donate a lot and is taxed by the United States should consider implementing a policy like the below. It's the most straightforward tax optimization, doesn't require a huge amount of work on your part, and can likely generate you at least $1,000 per year in additional donations because of the tax savings.
The three steps are (1) donating appreciated securities, (2) using a donor-advised fund, and (3) bunching donations. I will explain all of them, provide estimates of expected tax gains that you can modify, and help you develop a plan for implementing them. Also, there’s a link to a tax calculator spreadsheet at the end, which you can use to test different scenarios.
Those unfamiliar with how taxes work in the US might want to start with the final section, Quick intro to tax terminology
The three parts in brief
1. Donating appreciated securities
Donating appreciated securities (stocks, bonds, crypto, etc.) that you've held for more than a year is hugely tax advantageous, because you can claim the full market value of the security as a deduction against your income in addition to paying no capital gains taxes on the gain.
If you hold any appreciated securities in non-tax-advantaged accounts, it makes a lot of sense in my opinion to exclusively use those for your donations, and it might make sense to routinely invest savings into securities that can appreciate and be used for future donations. A typical donor can save as much as 15% of their donation's value by doing this, and perhaps more by preemptively investing in order to donate appreciated securities. If you're making $150,000 and donating $15,000 per year, then this could be worth as much as about $2,000 per year.
2. Using a donor-advised fund or Betterment
Donating appreciated securities is complex, and not every charity can accommodate a donation of a security. You can, in 10-15 minutes and for a very small fee, create your own donor-advised fund which will let you take the other steps of the plan here with much greater logistical ease. Additionally, a donor-advised fund lets your donations (as recorded for tax purposes) occur at whatever time would be convenient to you but sent to charities whenever you'd like, and they can earn market returns in the meantime. Donating appreciated securities to a donor-advised fund is likely to be at least as easy as donating them to a charity. I'll walk you through a quick guide to setting one up with Fidelity, which should take no more than 15 minutes (although donating appreciated securities will likely involve some wait time). You can also do this easily and for free with Betterment.
If you combine the amounts you plan to donate across two years into a single year, then you can gain the full tax deduction for the amount you donate and in addition claim the standard deduction in the next year when you don't donate. The standard deduction is currently $12,950 for individuals and $25,900 for married couples filing jointly. I estimate that the typical donor in a high-tax state can save approximately $800 per year by bunching donations every other year.
The three parts in detail
1. Donating appreciated securities
The benefit of donating appreciated securities that you’ve held for more than a year as opposed to cash is approximately three-fold:
- You end up with more money at the end because you acquired the securities for less cash than they're worth now (this works reliably enough because markets generally have positive returns)
- You avoid lots of taxes
- You avoid a big cash draw, which will make it easier for you to be resilient in the face of unexpected costs
First, there are three important caveats:
- This works way better if you've held the security for longer than a year, because you can’t claim the appreciated value of the security as a tax deduction otherwise.
- I am not a tax lawyer or accountant, this is not tax advice or whatever
- This doesn't provide tax benefits nearly as good if the security is held in a tax-advantaged account such as a 401k or IRA.
A worked example
You likely have appreciated securities whose market value covers your intended donations completely. In that case, donating the appreciated securities is strictly better than donating cash. If you didn't eventually use those securities for your donations, then you'd sell them and pay capital gains taxes on the amount you gained while holding them. Capital gains taxes are generally 15% of the gain you made. If you donate the securities instead of selling them, then you avoid this 15% tax on the gain you made, and you also can claim the entire value of the security as a tax deduction.
Here's a quick worked example. Suppose you own $15,000 of VOO, the Vanguard S&P 500 Index ETF that you bought a few years ago for $5,000, and you're trying to donate $15,000 to charity this year. There are three routes you can take:
|1. Sell ETF, donate cash proceeds||Pay capital gains taxes💸||Pay capital gains taxes💸|
|2. Hold ETF, donate cash||Can deduct cash donation from taxes🤑|
Will eventually pay capital gains taxes 💸
Might run low on personal cash 💵
|3. Donate ETF|
Avoid capital gains tax💰
No cash spend💵
Can deduct full value of ETF🤑
Got you more donation for same initial cash investment 💹
Can use your cash to invest in a similar position again 💹
1. Sell the ETF and separately donate $15,000 of cash. Because you held the ETF for more than a year and have $10,000 of gains that you realize by selling, you get taxed the 15% capital gains rate on the $10,000 gain and have to pay $1,500 to the government. Separately, you can deduct $15,000 from your income when it comes time to pay taxes.
2. Hold the ETF and donate $15,000 of cash. This also gets you $15,000 of tax deductions from your income as in #1, and it avoids the $1,500 capital gains tax mentioned above. However, one downside is that you need to have $15,000 of cash on hand to donate. One other downside is that the ETF will likely keep appreciating, and the more it gains, the bigger your tax bill will be when it comes time to sell it. The way out is to donate the ETF directly: see below!
3. Donate the ETF itself. This gets you the same $15,000 deduction from your income as the other two, and avoids the $1,500 of capital gains taxes, and also you don't have to dip into any of the cash you're holding. This is the best option. If you also don't want to stop holding the VOO ETF, you can buy $15,000 more after you donate your old holding.
As we can see in the example, donating appreciated securities (1) saves you money on taxes, (2) lets you donate more with the same amount of cash, and (3) lets you donate large amounts without liquidity problems
Some sources to substantiate my claim that donating appreciated securities means you avoid capital gains taxes on them
To go straight to the original source, you can look at the section of IRS Publication 526 on Charitable Contributions, “Giving Property That Has Increased in Value”. For less detailed accounts, see for example this piece by Schwab Charitable.
How to do it and caveats
One question you might have is "How do I pull off donating a stock directly to a charity? That seems complicated!" The best answer is to use a donor-advised fund or Betterment, which makes the process much easier. See below for more on that.
One other question you might have is, how much of a deduction can you use this for? Can you donate so much stock that you completely wipe out your tax burden? The answer is "not really".
You can't claim more than 30% of your income per year as a deduction by donating appreciated securities. However, you get 5 years of carryover for a donation that's too large. One initial year plus five years of carryover means 6 years over which to distribute your deductions, so with a constant AGI you could deduct the full amount of a donation equal to 6 * 30% = 180% of your AGI. For example, suppose you make $100k per year. That means that you can’t claim more than $30k as a deduction in a single year from a donation of appreciated securities, but if you were to donate $180k of appreciated securities and not have your income change, then you could claim $30k in that first year and carry over $30k to each of the next five years, eventually using the entire $180k donation
In addition, you can deduct up to 60% of your income in a given year by donating cash, so you could deduct 90% of your income in a year by donating 60% of your AGI as cash and 30% as appreciated securities. Cash donations are also able to be carried over for 5 years.
See https://www.irs.gov/publications/p526 for more details.
If you have appreciated securities (stocks or bonds) to donate, and if you've held them for longer for a year, and if you hold them in a non-tax-advantaged account, then those appreciated securities should be your next donations rather than donating cash. This is for precisely those three reasons above: by donating the securities instead of the cash, you'll avoid eventual taxes, you'll avoid dipping into your cash deposits, and you'll be able to reap market returns on whatever cash you have sitting around before your next donation.
If you don't have appreciated securities like the above to donate, but you're still saving money in addition to donating, then you probably should keep donating cash for now but try to redirect some of your savings toward buying securities that will appreciate. In addition to being a good strategy for planning your future donations, this is good personal finance advice more generally as well. Index funds are very likely the best for you. If this is news to you, or if you're not doing it but have the money to, then I recommend that you read the writings of Ben Felix or watch his videos for more.
The reason to buy these securities is that if they go up (which they very likely will), then you will have been able to donate more money and claim a greater tax benefit and help charities more than if you had just donated the cash instead.
One thing that I recommend you not do is the following. Feel free to skip this section if you’re not planning on getting particularly creative with how you’re going to get with generating capital gains.
Other people have discussed a strategy where you enter offsetting long and short positions so that you're likely to generate a capital gain that you then donate on one side and a capital loss that you use to offset expected gains elsewhere in your portfolio and lower your capital gains taxes. This is an interesting strategy, but I in my unprofessional opinion do not believe it will pass muster with tax authorities. See for example this article on straddles for tax purposes. http://www.nysscpa.org/most-popular-content/straddle-identifications-making-the-best-out-of-a-bad-situation
2. Using a donor-advised fund or Betterment
What it is
A donor-advised fund is a fund that you can create and donate to. It is required to disburse its holdings only to 501c3 charities. You can choose where and when it disburses its holdings.
This requirement that the fund disburses its holdings only to 501c3 charities allows you to count any donation that you make to your donor-advised fund as a 501c3 donation at the time you make it. In addition, the donor-advised fund can invest anything it holds in the market where it will earn positive returns and where gains will not be taxed.
Betterment also has a feature that allows users to donate appreciated securities. I don’t know much about it, but from a quick read, it seems to be at least as good as using a donor-advised fund. See this news article as well.
How it works
Donor-advised funds are generally easy to set up. It can take less than 10 minutes to do so. Many personal brokerages have associated organizations that will set up a donor-advised fund for you (see for example Fidelity and Vanguard. In general they charge a small fee (Vanguard charges 0.66% for a typical portfolio, and Fidelity charges 0.62% for a typical portfolio) and sometimes have a minimum balance or initial donation (Vanguard has these, but Fidelity does not). You should weigh these fees and constraints against the market returns you'll likely earn while your money sits in the donor-advised fund and also the tax benefit you get by being able to donate to them. Betterment’s similar feature seems to have no fees as well, which is an advantage if you have Betterment already set up.
Reasons you might not want to use it
- It slightly delays your donations relative to when you'd make them without a donor-advised fund
- A desire to donate to charities that aren't actually 501c3s
- Minimum donations and disbursements
- Disbursements can be denied sometimes, although this seems rare.
How to set up and use a donor-advised fund
1. Set up a fund: 5 - 10 minutes
I recommend Fidelity Charitable given the low costs and the ease of use. I was able to set up a new fund in less than 4 minutes. I can also vouch for the ease of setting up a fund on Vanguard, although I think that their fees and flexibility are worse..
2. Figure out what you want to donate to the new fund: ~30 minutes
I recommend donating appreciated securities to the fund. The approach I’d recommend is to look through any non-tax-advantaged brokerage accounts (i.e. not 401(k)s or IRAs) and see where your biggest unrealized gains are, and donate those.
3. Donate it: ~1 hour of active work, possibly weeks of passive waiting
In general you need to give a letter of authorization to your brokerage account so that they can do the donation of securities for you. This letter may take time to send to the correct place, and it may take a few weeks for the donation to be completed.
Also, I recommend that you be mindful of deadlines around year-end giving. It takes donor-advised funds time to receive and process any donations you make. I have missed this deadline for year-end giving in the past.
For example, in 2021, Vanguard Charitable recommended that mutual fund shares held outside Vanguard be donated by November 12 in order to be processed by the end of the year. Fidelity recommended initiating this process by November 15.
Other assets like private stock or crypto might require bespoke handling that could take longer.
A motivating example
Consider your planned donations over the following two years. Suppose you're planning on donating $15,000 in each of those two years, so $30,000 total. Then, in each of those two years, you get to claim $15,000 as a deduction against your income on your taxes. That's how donating without bunching works. Now, suppose that instead you donate the entire $30,000 total in a single year and nothing the next year. The total amount you donate doesn't change, but the tax implications work out better for you. This is because in the first year, when you donate, you get to claim $30,000 as a deduction against your income on your taxes. And in the second year, when you don't donate, instead of being able to claim nothing as a deduction, you actually get to claim the standard deduction, which is approximately $12,950 for individuals and $25,900 for those married filing jointly.
I calculate that a process like this can save a single donor in New York City who makes $150,000 per year and aims to donate $15,000 per year an average of $762 per year, after accounting for state and local taxes as well. It's not huge, but it's not not huge either. The amount goes up to about $1,500 per year on average if your state and local tax burden is low. You could get more aggressive than this, perhaps, and bunch even more than every other year and get additional years when you can claim the standard deduction.
There are two limits to consider:
- There are limits to how much of your income you can deduct in a single year. If you need to carry over donations from one year into another, you undo the benefit of being able to claim additional standard deductions.
- If you’d itemize your deductions even without making charitable contributions (for example because of state and local taxes or the mortgage interest deduction), then bunching is not going to provide you any benefit.
You might think that if your income is high enough, then you’re going to pay enough state and local taxes that it always makes more sense to itemize than it does to take the standard deduction. It seems to me that this isn’t true in New York, at least, because there’s also a (smaller) standard deduction for New York taxes, and you can decide whether to itemize on your NY return separately from whether to itemize on your federal return. The calculator I built seems to agree with me here. The upshot is that you should run the numbers in a calculator you trust before ruling out this strategy.
See additional discussion here: https://www.benkuhn.net/bunching/ and try out the calculator below, which will tell you what benefit bunching will give you
Calculate your estimated taxes
I built a tax calculator on Google Sheets. The calculator is meant primarily to calculate the benefits of bunching, but it also lets you know how much money any deduction will save you. Feel free to make a copy, input your numbers, and modify as you see fit.
Quick intro to tax terminology
In case you don’t have much background on taxation in the US, here’s a simplified version of how it works and what the terms mean:
- You earn money at a job or something, this is probably the majority of your income
- Your employer probably withholds some of your earnings because it estimates your tax rate, and it sends those withholdings to the government on your behalf. These count as taxes that you paid.
- The IRS bases its calculations on adjusted gross income, which excludes things like student loan interest or contributions to retirement accounts
- You can lower your income for tax purposes, called your taxable income, even further by taking a deduction against your income. You have two choices about how to do that. The standard deduction is currently $12,950 for individuals, and you can subtract that amount from your adjusted gross income. You can also itemize your deductions (i.e. list them separately) if you think it will result in a bigger deduction and lower taxable income. All of the strategies discussed here involve maximizing the size of these deductions.
- A calculation is done on your taxable income to calculate your tax, and then if your withholding that you already paid is bigger than your tax, then you get a tax refund. Otherwise, you owe taxes.
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