In this episode, John and Bridget discuss all things Donor Advised Funds (DAFs) and Qualified Charitable Distributions (QCDs) and how to decide which strategy to use when making charitable contributions. They break down the highlights and mechanics of each option and provide insightful tips on making the best choice based on your specific situation.
Check out our previous episodes on DAFs!
Basics about Donor-Advised Funds: https://youtu.be/g7jbhnLcNDw
How to maximize your Donor-Advised Fund: https://youtu.be/dSsNF6bWjVk
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John's firm website: https://www.trinfin.com
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TRANSCRIPT:
John: When you're giving money to charity, is it better to do a donor-advised fund or a qualified charitable distribution? In today's episode, we're going to have a battle of financial jargon and decide whether a DAF is better than a QCD. Hi, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: And I'm Bridget Sullivan Mermel, and I'm fee-only financial planning in Chicago, Illinois. And before we move on with the battle of the acronyms, let's make sure you subscribe. That helps us with YouTube and helps more people reach our channel. So, John, donor-advised fund, and qualified charitable distribution. Let's start with the donor-advised fund and talk about just a few of the highlights of the donor-advised fund.
John: So we're talking about giving money to charity, especially as we're around the end of the year holidays. And there’re a couple of better ways to give than just writing a check or sticking money in the bucket when you go to the grocery store. And we work really hard on our show to try to avoid financial jargon. We got the jargon police, but there are some of these titles that are helpful, and I think it is useful to not have to say everything. So donor-advised fund, DAF.
Those are the initials that come in here. We've had a couple of episodes recently on donor-advised funds. We'll put links in the show notes to those. But a donor-advised fund is like a mini foundation that you can set up at Schwab or Fidelity or Vanguard or your local community foundation, where at very low cost and low overhead, you can put money into a fund and take a tax deduction for it when you put the money in. But then you can let that money grow and distribute it over time to various charities.
If you want the details, we'll put those links to the videos where we describe it in detail, but one of the big advantages of the donor-advised fund, or the DAF, is that I can take an investment that's gone way up and put it in. For example, if I bought $10,000 worth of Apple stock and now it's worth $100,000, I could give all $100,000 of stock to the donor-advised fund and pay zero taxes on any of those gains because it's going to charity.
Again, there are more details you can see in the previous episode, but that's sort of the crux. I can avoid taxes on this thing that's gone up. That can be a really great deal. But then there's another tool that we can use also, and maybe I'll turn it over to you, Bridget. Qualified charitable distribution, or QCD. Can you talk a little bit about the structure of that?
Bridget: A qualified charitable distribution, or QCD, is something that comes out of your IRA, so you have to be 70 and a half for this to be in play. You have to be over that age. For a donor advised fund, it doesn't matter what age you are; you can do a donor-advised fund. For the qualified charitable distribution, however, you have to be over 70 and a half, so that's the biggest issue with it. But what are the mechanics of it? You have an IRA.
You get a checkbook from your IRA, and then you can write checks directly from the custodian to the charity, and then they can cash them. And that counts as part of your required minimum distribution, and it doesn't count as income to you. So they get the full amount, but you don't end up paying tax at your regular income tax rate on it. This is an awesome thing. It's great. And that's really the beauty of it. You can only give $100,000 a year, but I don't see that as an obstacle for most people.
John: Right. And I just wanted to pull out there that you're not taxed on it, so the money goes into my IRA through maybe my 401K or 403(b). I got all this pretax money that's never been taxed in my IRA. If I take it out, I will have to pay taxes. Even if I then write a check to charity, it depends on my situation. Maybe I get a deduction, maybe I don't, because of my itemized deductions. Here you get into some arcane things in the tax law, but if I write a check from my IRA and it goes to United Way or church or wherever, there's no tax.
That money is 100% pretax; I avoid taxes on all that money. That's where some of the magic comes in with this QCD; it’s complete tax avoidance. Of course, you're giving the money to charity. It's not a free lunch. But listen, if I'm going to give money to charity anyway, that QCD, the qualified charitable distribution from the IRA, is something I need to think about.
Bridget: Right.
John: So, look at these two options. Donor-advised fund. I can give stock that's gone way up, and I don't pay taxes on it when it goes to charity. And the QCD, or qualified charitable distribution, I can take money that's never been taxed and give it to charity tax free. What's your take on this Bridget? Which one do I do? And we get this question periodically. I'm interested in your take because got a client who has a lot of investments that have gone way up. I could use the donor-advised fund, but I'm also over 70 and a half. I could do this qualified charitable distribution. Which one's better?
Bridget: Well, we're going to talk in general. To me, you have to look at your specific situation, because there can be factors that make it different in your specific situation. But I would say if you're under 70 and a half, it's donor-advised fund. And if you're over 70 and a half, the QCD is generally at least as good of a deal or a better deal than the donor-advised fund. And the reason for that is the donor-advised fund saves you tax, basically at the capital gains rate versus the QCD, which saves you tax at your regular income tax rates, which are generally higher.
So that's my rule of thumb. Now, I have some clients that don't want to mess around with QCDs, and they itemize, and they take money right out of their IRA, and Illinois doesn't tax that. There can be exceptions to the rule, or they might not even have much money in a taxable account, so then for sure it's a QCD. I think that age is the biggest tipping point.
John: Yeah, I agree with you. For me, I'll put even a little finer point on it. If you're under 70 and a half, you can't do QCD, so that is the only option if you're over 70 and a half. And I appreciate that. There certainly can be some instances. It's hard for me to think of any of them. Being in Wisconsin, Illinois, there's no tax on IRA distribution, so that changes the metric perhaps a little bit for folks that are local to you, but 98% of the time, I expect that when that question comes up, that QCD, doing it from the IRA is, in general, what I expect to be a better deal.
And you just described it very well. I appreciated that. Listen, when money comes out of your IRA, you're paying regular income tax rates, which are higher than the capital gains tax rates. The other thing that comes up for us with those sorts of decisions, or why I landed on the QCD and giving money from your IRA being a better deal, is for many of our clients, they're not going to use all the money that they have. This money is going to go to kids and grandkids in some fashion. And as you just described, listen, if I'm going to use my money today, taking it out of the IRA is a higher tax rate.
Let's give that one to charity, and if I need to sell some stock, even for that Apple stock that's gone up 1000%, I'm only paying 15%, probably in capital gains tax. But take that a step farther down the road. And listen, money that's going to my kids, if I leave an IRA to my kids, they have to take that money out all within ten years now and pay the regular income tax rates at their tax rate on it. If I leave them behind that Apple stock that's gone way up, they get the so-called step up in basis, meaning I put in $10,000, now it's worth $100,000. When I kick the bucket, they get that money and can sell it with no capital gains tax at all.
So on the stock side of things, going to the donor-advised fund, all things being equal, a donor-advised fund with appreciated stock totally makes sense when we're talking about I can take something in an IRA that is going to be taxable to somebody and make that tax free going to the charity, or I can take the stock that may be taxable if I sell it, but may be tax free to my kids, that's a really great deal, which again points me in that direction of taking that money from the IRA and going to charity; in other words, making that money that's taxable to somebody else all the time, making that tax free in going to the charities where there's real power.
Bridget: I really like your points as well about inheriting, but there's another point I want to make too, and that is for people who are over 70 and a half and are taking the required minimum distributions which are more than they spend, so they have to take out more than they want, and they give a decent amount to charity. That isn’t included in your adjusted gross income, the QCD. So for Medicare part B and D, that is based on your modified gross income, and so if you're concerned about that, I think right now, the limit is if your income is under…around $200,000.
John: Something like that.
Bridget: Yeah, it's in that range. But if your income is over that, then you have to start paying for Medicare Part B and D. And so that's another thing that people should watch for.
John: You just made me think of two other things here, and then we'll wrap things up. But one is, listen, I don't need my minimum distribution. I have to take money out of my IRA, but I don't need that money. Great, let's give it to charity. We've got other folks, too, who are spending all their money from their RMD from their IRA. They might say something like, right now, we're using all our RMD. We didn't have to take out $30,000. We're taking out $40,000 to live off.
Even though it can get convoluted with RMDs, giving above that limit, I think still makes sense for those reasons we talked about. And then one last thing before we wrap up is when you do write those checks from your IRA and it goes to the charities, those checks have to be cashed before the end of the year. It's not like other charitable donations where if I write the check today, I get credit when I write it. It's when the charity cashes the check, so you just got to be aware of that at the end of the year here.
Bridget: Exactly. So I encourage people to make donations before December, and be checking them. And sometimes people even call the charity and say, “Hey, cash the check.” That's awesome, John. With that, let's wrap it up. I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee only financial planning practice in Middleton, Wisconsin, and both Bridget and I are taking on new clients. We'd love to hear from you. But if you like what you hear, and you'd like to have an advisor in your local area, both Bridget and I are members of the Alliance of Comprehensive Planners, a group of fee-only, tax focused financial advisors who think similarly to us. If you want to find an advisor in your area, check out acplanners.org.
Bridget: And please subscribe.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.