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Optimal Gifting for Financial and Philanthropic Return

Active Tax Management
December 8, 2017

As the end of the year approaches, many of our clients are thinking about making contributions to their favorite charities or through their donor-advised funds or family foundations. Well-informed investors are likely also considering the tax implications of their charitable giving. For some taxable investors, their generous impulse has the potential to benefit not only the gift recipients and their causes but also the investors’ own bottom lines, even beyond the charitable giving season. Identifying the approach that might lead to the most beneficial and timely gifting plan is a subject Aperio found worthy of examination.

In our empirical study “The Double Bottom Line—Tax-Loss Harvesting for the Altruistic Investor,” we tested gifting strategies to measure their potential impacts on the after-tax alpha generated in an optimized, index-tracking portfolio in which tax losses are harvested. Tax-loss harvesting (TLH) in such a portfolio has historically generated substantial after-tax alpha (see “Indexed ETFs vs. Indexed SMAs: A User's Guide”), but it lowers cost basis, so harvesting opportunities tend to diminish over time.

Accordingly, a strategy that elevates cost basis can improve after-tax alpha. One such approach is optimal gifting—that is, donating highly appreciated shares and replenishing with cash. Gifting appreciated assets instead of cash avoids the capital gain hit of selling, while contributing a positive social impact. Donating from TLH accounts to remove such assets from the portfolio raises the cost basis of the account, refreshing loss harvesting with cash replenishment.

Using our After-Tax Back-Testing Analysis Tool (ATBAT), we set out to quantify the benefits of this strategy, questioning the amount of excess after-tax alpha to be gained in an optimal gifting strategy, the relative impact of optimal gifting on after-tax alpha in the estate/donation versus liquidation scenarios, the effect on after-tax alpha of optimal gifting at different horizons, and the ideal frequency at which to gift and replenish with cash.

Our historical study over the period December 1972 to January 2017 simulated donating a fixed percentage of 0.25% and 0.5% (annualized 3% and 6%) of the account value each month during rebalancing and replenishing with cash, tracked return and risk at annual horizons as strategies evolved, and aggregated results by horizon.

By elevating cost basis, the analysis found, optimal gifting bolstered after-tax alpha in both the estate/donation and liquidation dispositions. The chart and table below highlight the results at a 10-year horizon, compared to a base case of no optimal gifting.

gifting charts

The improvement in tax alpha is evident, particularly in the liquidation disposition. At the same time, tracking error (our measure of risk), which tended to drift upward for TLH strategies with no gifting as horizon lengthened, was under 1% even at a 20-year horizon for 3% optimal gifting.

When we looked at the difference between optimal gifting just once a year in December versus monthly, we found that, at a 10-year horizon, the median difference in after-tax alpha earned by optimal gifting at annual and monthly frequencies was minimal, ranging between –0.03% and 0.09% across the estate/donation and liquidation dispositions.

All told, we believe that taxable investors who are considering making year-end charitable donations may well benefit both themselves and others by incorporating an optimal gifting strategy with tax-loss harvesting.

For details on methodology, disclosures, and additional results, see the full report.

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This article is provided for informational purposes only. The information contained within this article was carefully compiled from sources Aperio believes to be reliable, and it is accurate to the best of our knowledge and belief. However, Aperio cannot guarantee its accuracy, completeness, and validity, and cannot be held liable for any errors or omissions. All information contained herein should be independently verified and confirmed. Aperio does not accept any liability for any loss or damage whatsoever caused in reliance upon such information. Aperio provides this information with the understanding that it is not engaged in rendering legal, accounting, or tax services. In particular, none of the examples should be considered advice tailored to the needs of any specific investor. Aperio recommends that all investors seek out the services of competent professionals in any of the aforementioned areas. With respect to the description of any investment strategies, simulations, or investment recommendations, Aperio cannot provide any assurances that they will perform as expected and as described in this article. Past performance is not indicative of future results. Every investment program has the potential for loss as well as gain. You cannot invest directly in an index.