Executive summary:
- Although cash donations are appreciated, donating securities may be more impactful for both the charity and the donor
- Investors receive tax benefits from donating securities and the charity receives the full value of the securities
- Using a Direct Indexing strategy may provide even more potential benefits, including avoiding capital gains taxes on highly appreciated securities
As we start to prepare for the year-end holidays, many of your clients may be getting into the spirit of the season and thinking about making a charitable donation or increasing their charitable giving.
While most charitable donations made by individuals in the U.S. are made in cash and there can be tax benefits to doing so, there may be an even more impactful approach to donating. Rather than donating cash, an investor can donate appreciated securities to their chosen charity. The charity is then free to sell the investment or hold onto it and potentially benefit from further appreciation. Charities don't have to pay federal income taxes on gifts, so that's a win for them.
Meanwhile, the investor can deduct the gross value of those securities from their income tax (subject to certain limitations), as well as avoiding the capital gains tax they would have paid if they had sold the shares for cash. We see that as a double win for the investor.
Using a Direct Indexing strategy can provide even more potential benefits beyond the tax savings.
Direct Indexing allows the investor to directly own a subset of stocks that closely replicates an index, determined by the asset manager who manages the portfolio. Because the client owns the actual underlying securities rather than as part of a mutual fund or Exchange-Traded Fund (ETF), direct indexing allows for a level of flexibility in what subset is owned in partnership with the asset manager.
The power of donating highly appreciated shares
One method is working with your direct indexing asset manager partner to help determine which securities should be gifted from the direct index portfolio to charity. By working hand-in-hand with the asset manager, they can help you determine the right stocks to gift to charity that will both help remove securities with high embedded gains while not requiring an unintended tax consequence or deviations from the index once removed.
The advantage to donating shares is that the investor gets a charitable deduction for the current market value of the shares, not what was originally paid, or the net value of what the investor would keep after paying capital gains tax.
The potential tax benefits of donating stock
As we've already discussed, donating stock instead of cash holds a number of potential tax benefits for investors. Let's dig a little deeper to see just how much of a win-win-win strategy it could be.
When an investor chooses to gift highly appreciated securities, they gain the advantage of disposing of the asset without incurring any capital gains tax.
For example, if your client contributes an appreciated security that has a cost basis of $50,000 and a fair market value of $100,000, they may take a deduction equal to $100,000 (subject to certain limitations) and the charity could receive a gift worth $100,000.
On the other hand, if they sold the securities and donated the after-tax proceeds, the charity may receive only $90,000. That's because the donor would have had to pay a 20% capital gains tax on the $50,000 difference between the current market value of $100,000 and their original cost of $50,000. In addition, your client would receive a smaller charitable tax deduction. This is a hypothetical illustration and every client's situation is different.
If your client was intending on donating cash, they could instead use the money to replenish their investment portfolio to equal the value of gifted stocks. This can result in a cost-basis increase that improves the potential for future tax-loss harvesting, possibly helping reduce capital gain taxes down the road.
Americans are indeed very generous people. In fact, every year Americans donate billions of dollars to charity. According to the Giving USA Foundation, Americans donated $499.33 billion to charities in 2022, most of which came from individuals.1
As we enter the season of giving, it may make sense to consider the idea of implementing direct indexing for your clients' charitable gifting strategy. Not only will they possibly reduce or eliminate future capital gains on their gifted shares but by reinvesting the cash they intended to gift, the investor can reset their cost basis to a higher level and receive the future potential growth of the market, possibly allowing for larger gifts in the future.
Happy Holidays!
1 Source: https://givingusa.org/giving-usa-limited-data-tableau-visualization/
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