Strategic giving: How Direct Indexing could enhance charitable contributions

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

Generosity knows no season. But as the year-end holidays approach, many of your clients may be thinking about making a charitable donation or increasing their charitable giving.

Most charitable donations made by individuals in the U.S. are made in cash and that’s great. It’s easy and there are some tax benefits to doing so.

But here’s a game-changer. Donating securities can be a win for the charity and a double win for the donor.

When an investor donates securities, the charity can sell the investment and reap the benefits or hold onto it and potentially benefit even more from further appreciation. Most 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

As an advisor, you can work with your direct indexing asset manager partner to help determine which securities from the direct index portfolio should be gifted to charity. Together you can determine the right stocks for your client to donate that will both help remove securities with high embedded gains while not triggering an unintended tax consequence or cause the portfolio to deviate from the index.

As we’ve already discussed, donating stock instead of cash holds several 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 these assets without incurring any capital gains tax. That’s a win. Meanwhile, the charity gets the full value of the appreciated shares. That’s another win.

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 your client 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 the 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. And that’s yet another win.

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 $557.2 billion to charities in 2023, a substantial increase from the $499.33 billion donated in 2022. Importantly, two-thirds of the money donated 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. Direct Indexing can be a way to possibly elevate the impact of charitable giving.

Happy Holidays!

¹ https://givingusa.org/giving-usa-limited-data-tableau-visualization/