Although it is widely underused, donating appreciated securities is perhaps the most straightforward and tax-smart way to give.
A 2007 Fidelity Investments study estimated that Americans pay an extra $2 billion to $4 billion annually in taxes by donating cash instead of appreciated securities. By donating a stock or mutual fund with a long-term gain, clients can avoid paying any capital gains tax and are credited with the full fair market value as a charitable deduction.
Many clients, unaware this is allowed, donate only cash to charities, losing out on paying less in capital gains taxes year after year. Advisers should educate clients about this aspect of the tax law.
Donating securities is a particularly useful strategy, along with a disciplined sell strategy. When positions exceed performance expectations and a sale is warranted, the tax hit can be reduced or eliminated by donating the securities. Conversely, a large gain can make investors reluctant to reduce top performers, leading them to sell only when the assets go down in value and the taxes are lower. Of course, selling low instead of high is a big mistake.
For example, say a new client holds a third of his entire equity allocation in one stock, which was inherited in the 1960s and has grown spectacularly. Now is an appropriate time to sell part of the stock and diversify the portfolio. However, since the cost basis is so low, taxes are a major stumbling block. But by donating a portion of the shares to a donor-advised fund — which allows clients to get a current-year tax deduction while dispersing donations over multiple years — the taxes are significantly lowered. This strategy would pre-fund the client's charitable budget for about five years. The cash that would have been donated to charity is thereby freed up to invest.
Pre-funding charitable contributions with a donor-advised fund has the added benefit of advancing the tax deduction. The savings from the tax deduction can be invested and — assuming constant tax rates — can significantly outpace the value of taking a smaller deduction each year. This is a particularly useful strategy in years of unusually high client income, when the client is in a higher-than-average marginal bracket and the charitable deduction is particularly valuable. However, because of the uncertainty of future tax rates and laws, in most instances, we recommend limiting pre-funding to five years of future donations.
Brokerage account holdings are not the only good source of donations. Real estate and even businesses can be donated to charity. This is a conversation to have with clients well before the sale is made, especially since the tax law is complex.
For instance, if clients own a second home bought years ago and face a large capital gain if the house is sold, a partial share of the house can be donated to a charity or a donor-advised fund, resulting in an immediate tax deduction for the client. When the home is sold, the charity receives a portion of the proceeds, and the client avoids capital gains on the charity's share. Pairing such a move with a donor-advised fund can be an easy way to establish a lifelong fund for clients to distribute to their favorite charities. Unfortunately, clients often don't inform their financial advisers about selling these assets until after the fact. Incorporating discussions of all assets, not just brokerage accounts, can help spot these important tax savings opportunities in advance.
Incorporating charitable donations as part of an investment strategy is another way to be a socially conscious investor. While there are many “socially responsible” mutual funds, no one fund necessarily fits a specific person's definition of social responsibility. One person may praise a company's fair labor practices and want to buy the stock, while another person may find that same company's environmental stances unacceptable.
An adviser can help a client establish his or her own socially conscious fund in the form of a donor-advised fund. When it is time to re-balance a portfolio, instead of selling off an entire appreciated position, part of the position can be donated to the donor-advised fund. The client can then apportion donations to the organizations he or she deems to meet social criteria.
As with any tax-related issue, your client's accountant should be consulted before any decisions are made. Not only will the nitty-gritty of the tax ramifications be examined before irrevocable steps are taken, but the discussion gives an adviser an opportunity to start an dialogue, integrating a client's tax and investment strategies, and improving long-term results.
Jonathan Bernstein is a financial adviser at Altfest Personal Wealth Management.
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