Bunching donations via DAF: Save another $130k in taxes

My recent posts have explored the efficiency (or inefficiency) of various charitable donation strategies:

• First, I explained why donating on credit cards is typically terribly inefficient, but that under certain circumstances could actually generate tax arbitrage.

• My next post outlined how donating appreciated stock instead of cash could generate over $100k in lifetime tax savings.

This post continues the theme with a discussion of my personal favorite approach for charitable giving: bunching donations via a Donor Advised Fund (DAF).

TLDR: Set up a DAF. Make 2-3 years of charitable donations to your DAF in a single year so more of your giving clears the standard deduction hurdle. Invest the balance within the DAF. Give to your desired charities via grants from your DAF (same $$ and timing as you would have otherwise.)

Employing this strategy could save you $130k over the course of your working years. It also makes it easier to donate appreciated securities, which could generate an additional $100k+ of tax savings.

Saving $230k is meaningful. This might allow you to retire a year or two earlier.

Or, using the 4% rule, this would give you ~$9k more annual spending money in retirement.

High impact, low effort. Let’s dive in.

For most Americans, charitable donations aren’t lowering their taxes

The US tax code offers the potential for charitable donations to lower your taxes. Under certain circumstances, giving $1 more to charity lowers your taxable income by $1. Your tax bill then decreases by your marginal tax rate – which could be as high as 50% for high income households in states with high taxes.  

However, most people aren’t getting this benefit.

The reason is that the government gives everyone the ability to deduct a certain amount of money from their earnings regardless of if they donate to charity or not. This is called the standard deduction.

To minimize your taxes, you want the largest deduction possible: thus, you’ll only itemize if your itemized deduction is larger than the standard deduction.

While there are numerous items that can potentially be included in your itemized deduction, there are 3 core ones that apply to a wide range of people:

1. State and Local Taxes (SALT) – In most cases this is your state income tax plus the property tax you pay on your home. The amount you can claim is capped at $10,000.

2. Mortgage Interest – Interest paid on the first $750,000 of mortgage debt for a primary or secondary home.

3. Charitable Donations – The amount you can claim is subject to a few limits. Relevant to my last post, your deduction is capped at 30% of AGI if donating appreciated securities.

If you take the standard deduction, then the charitable donations you made that year aren’t lowering your taxes at all. (Remember: donations only reduce taxes if you itemize, and you’ll only itemize if doing so exceeds the standard deduction.)

The Tax Cuts and Jobs Act of 2018 greatly increased the amount of the standard deduction. For MFJ taxpayers (married filing jointly), the standard deduction ballooned from $13,000 in 2017 to $24,000 in 2018. In 2024 it stands at $29,200.

With the standard deduction increasing so dramatically, the share of taxpayers who itemize deductions fell from 31% in 2017 to only 9% in 2020.

This means that for most Americans, charitable donations are providing no tax relief.

Introducing the Donor Advised Fund (DAF)

A donor advised fund is a special type of 501(c)(3) organization that serves as a sophisticated financial intermediary between you and the ultimate charities you want to support.

Here’s how it works:

1. You make an irrevocable contribution of assets to your account within the DAF (preferably appreciated securities). For tax purposes, this contribution to the DAF can be claimed as a charitable donation on your itemized deduction.  

2. You can invest the assets for as long as you want, giving your balance the opportunity to grow tax-free.

3. To distribute money, you make ‘grants’ to your charities of choice. The DAF sends the charity either an EFT or a paper check (which are extremely cost-efficient ways for them to receive donations). You can choose to either have your name on the gift, or for it to be anonymous.

DAFs provide numerous non-economic benefits that I find to be valuable. It gives you a single platform where you can easily see all your charitable activity. And you get a single end-of-year statement which greatly simplifies your record-keeping.

One economic advantage to DAFs is that they make donating appreciated securities much more feasible. In practice, giving stock isn’t worth the hassle for smaller gifts. And less sophisticated charities often don’t know how to receive these non-cash gifts. However, using a DAF, you can easily fund the account solely with appreciated stock, thus powering all your grants with this tax advantaged approach regardless of grant size and end-charity sophistication.

But the main purpose of this post is to explain how many people could generate significantly more tax arbitrage by utilizing a DAF and “bunching” their charitable contributions.

This strategy will exploit 2 key features of the DAF: 1) The tax benefit of your contribution is realized when you contribute to the DAF; and 2) you can delay when you grant the money to end-charities.

The bunching strategy in action

Let’s consider 3 couples. All have household income of $180,000 that will grow by 3% annually, have no mortgage debt, have annual SALT taxes of $10k+, and live in a state with a 4% income tax.

Stingy Sam

Stingy Sam and his wife don’t make any charitable contributions. It is optimal for them to take the standard deduction. They will pay $92,180 in state and federal income tax over the next 3 years.

Uninformed Upton

Uninformed Upton and his spouse generously give 10% of their AGI to charity. Despite annual charitable donations of $18-19k, it is still optimal for them to take the standard deduction.

Thus, their 3-year total tax bill is the same as Stingy Sam’s: $92,180. Like many Americans, their charitable gifts fail to provide any tax savings.

Intelligent Isaac

Intelligent Isaac and his wife Rebekah are savvy users of a DAF. In year 1, they contribute ~$51k. After distributing $18k to charity, they invest the rest in a total stock index fund that generates a 10% return, less a 0.015% mutual fund expense ratio and a 0.60% administrative fee to the DAF.

First, note that by design, the grants to charities are identical to both couples above. From the charities’ perspective, nothing has changed.

“BOY” = Beginning of Year. “EOY” = End of Year.

However, what has changed is Isaac and Rebekah’s tax situation.

The ‘super-donation’ in year 1 now makes it optimal to itemize their deductions that year. As seen below, their total itemized deduction is now ~$61k in year 1 – an increase of almost $32k vs Uninformed Upton.

In years 2 and 3, Isaac and Rebekah have no charitable contributions (for tax purposes), and thus take the standard deduction.

The result is that Isaac and Rebekah pay $8,244 less in taxes over the 3-year period than Uninformed Upton, while delivering the exact same charitable outcome. Pretty incredible for just being smarter about how to administer their giving.

Key insight: Bunching multiple years of donations into one year allowed a larger percentage of their gifts to clear the standard deduction hurdle. Conversely, it minimized the donations that fell below the standard deduction and were doing nothing to lower taxable income.

Sizing the prize

Testing this strategy over a range of inputs shows that 3-year tax savings could be $10k under the right circumstances (representing $3,300 annually).

Over a 40-year working career, that’s over $130k in tax savings from this strategy alone!

This strategy can be hugely tax advantageous for some households, but destroy value for others.

To determine its value for you, consider two key questions:

1. Excluding charitable donations, what would your itemized deduction be?

2. Would 2-3 years of donations materially clear the standard deduction hurdle?

If your answer to #1 is more than the standard deduction, then bunching likely would make you worse off. In these situations, you will already be itemizing and thus 100% of your giving is already lowering your taxable income each year. By donating early, you ultimately get a smaller total deduction since you gave the assets away before they appreciated 10% each year.

Example: Someone who recently took out $750k+ in mortgage debt on a 30-year loan at the current rate of 7.5%. This mortgage generates around $50k of deductible interest. This household will find it optimal to itemize every year regardless of charitable giving and will already get “full value” of any charitable donations.

If your answer to #1 is less than the standard deduction, then see if adding 2-3 years of donations allows you to clear the standard deduction. These are the situations that generate the additional tax arbitrage.

In practice, this will likely be most advantageous for charitable households with little mortgage interest who are in high marginal tax rates.

Selecting a DAF

There are many providers of Donor Advised Funds. Most people would do well with either Schwab or Fidelity. Both charge an AUM fee of 0.60% for assets on balances less than $500k and allow individual grants as low as $50. If you already hold assets at one of these brokerages, that would be a good reason to pick their DAF. You can see a Bogleheads discussion on the topic here.

While I’m a huge Vanguard fan in general, I don’t think their DAF is as good. They require a minimum grant of $500, making it less versatile for your full range of giving. They also have a $25k minimum initial donation, whereas Fidelity and Schwab have no minimum.

Personally, I have used Fidelity Charitable for the last decade and have had a positive experience.

Postscript

If you are required to take RMDs, making qualified charitable distributions (QCDs) is likely an even more efficient way to make your charitable donations. So the DAF/bunching strategy is likely to only be used by working households prior to RMDs kicking in.

I hope you bristled at my mention of DAFs charging a 0.60% AUM fee. After all, keeping costs low is critical to maximizing after-tax returns. In my example above, the tax arbitrage from bunching greatly outweighed the costs of paying the DAF fee (which was baked into my analysis).

If you aren’t bunching, you may still want to use a DAF for its other benefits. But it likely makes sense to use the DAF as a passthrough vehicle, i.e. grant the money relatively quickly after you contribute to the DAF. This way your funds aren’t exposed to the 0.60% fee on an ongoing basis.