When it comes to charitable giving, choosing a charity is only part of the process. In fact, there are a number of different approaches to philanthropy, and individuals need to consider all the possibilities before they decide on the best one for their personal needs. Thinking critically about the tax consequences of each strategy can not only help people get the best tax breaks, but it can also enable their gift to make the biggest impact.
The following are some of the key tax-friendly methods of giving that donors should consider:
Charitable Remainder Trusts
A type of private fund, a charitable remainder trust allows individuals to designate beneficiaries for taxable income for a certain number of years or for life. Money that is left over after this income is disbursed, known as the “remainder,” is then funneled to charities without being taxed. Further, people can deduct contributions to the trust from their taxes based on projections of how much money will go to charity. Individuals control the trust or designate a specific trustee, and income generated by the trust is either set or recalculated each year depending on the stipulations made when the fund was created. In addition, income is capped by a minimum amount that must go to charity.
Individuals should take several considerations into account when creating a charitable remainder trust. This strategy involves significant investment risk and responsibility without much protection against longevity risk. At the same time, these funds are a good idea when individuals have appreciated securities in their portfolio, and they do not want to pay capital gains tax, or they need a large charitable deduction to offset a gain. People can also contribute appreciated securities, including stocks, bonds, and mutual funds, to the trust.
Pooled Income Funds
Pooled income funds look like charitable remainder trusts in many ways. However, they are different in one very important aspect. Pooled income funds are administrated by a charity, so donors have much less work to do, although they must pay an annual fee for this service.
With this charitable strategy, contributions from a variety of different owners are pooled into a single fund and then the charity invests the proceeds. Each year, the charity makes taxable payments to donors in an amount commensurate with their total donations and then keeps the remainder. Like with charitable remainder trusts, contributions are tax deductible based on the amount of money projected to benefit the charity. Again, contributing appreciated mutual funds, stocks, and bonds, can help people avoid capital gains taxes.
Charitable Gift Annuities
By setting up a charitable gift annuity, philanthropists can secure lifetime income from appreciated securities while benefiting charities. With this method, donors give a large, irrevocable gift, such as an appreciated security, to a charity. In return, donors receive a lifetime taxable income stream. The deduction that donors can take after setting up an annuity is based on an IRS formula that estimates the remainder of the income that will be left for the charity at the time of the donor’s death. This strategy avoids much of the hassle and administrative headaches involved with charitable remainder trusts.
One of the downsides of charitable gift annuities is the fact that the fixed income from the donation is not protected from inflation. Individuals also need to think carefully about the longevity and creditworthiness of the charity because they are depending upon it to provide them an income for the rest of their lives.
A donor-advised fund is managed by a charitable organization rather than an individual donor. Each donor pays an annual administrative fee to the organization for setting up the fund and handling compliance matters. The benefit of this setup is that donors have complete control over how their portion of the fund is invested. They can also choose the charities that receive distributions from fund earnings.
Philanthropists can name their portion of the fund and receive a tax deduction based on the amount that they donate to the fund in a given year. A donor-advised fund gives philanthropists a great deal of control and focuses on giving rather than generating income without the administrative headaches that come with personally managed funds.
A single person or a group of individuals join forces to create a private foundation, which, according to the IRS, is considered a tax-exempt charitable organization. People can deduct contributions to a private foundation from their income for tax purposes up to a limit, which both federal and state policies define. Typically, foundations must distribute at least 5 percent of their total value to charities each year.
Private foundations are a good choice for people with a high net worth who want complete control over their charitable giving. Before setting up this sort of account, though, individuals should look at the costs involved, including ongoing fees for legal advice to ensure compliance. These expenses can add up very quickly.