If you have appreciated stock or mutual funds in your taxable account, you will have to pay capital-gains tax if you sell them. However, by donating appreciated securities directly to a charity you can forgo paying tax as long as you have held the securities for more than one year. (The deduction is limited to 30% of your adjusted gross income for most charities, rather than the usual 50% limit; consult your tax advisor or see IRS Publication 526, Charitable Contributions for details.)
The benefit of this type of donation is equal to the value of the tax deduction. If you donate $10,000 worth of a mutual fund and you paid $5,000 for the shares, you avoid a $5,000 long-term gain, saving $750 at the 15% tax rate. The charity, since it is tax-exempt, can sell the shares itself and pay no tax.
Note that if you have shares with a loss, you should not donate them to charity; instead, you should sell them, claiming the capital loss which will reduce your taxable income, and then donate the sale proceeds to the charity.
Donating securities at Vanguard
To donate mutual funds with Vanguard, go to Forms, then under "Change of Ownership", select "Giving Fund Shares to Organizations" to give shares of mutual funds; fill out the start of the form yourself and have the charity fill out the rest of the form. If the charity does not wish to hold the fund, one of the options allows the charity to ask Vanguard to sell the fund and give it the proceeds in cash.
To donate securities from a Vanguard brokerage account, select the form "Letter of Instruction for Gifts of Securities". The charity must already have a brokerage account (not necessarily with Vanguard); you can get this information from the charity and fill out the form yourself. If the charity also has a Vanguard brokerage account, you may need to use the "Change of Ownership between Nonretirement Accounts" form.
Since you pay no tax on the donation, you would usually want to donate your lowest-basis shares which have a long-term gain. If you donate non-covered mutual fund shares, Vanguard will only provide average-cost information. If you are using specific identification of shares for tax purposes, you need to identify which shares are being donated in the same way; send Vanguard a secure E-mail, or enclose a letter with the form, which says, "Please donate $10,000 (or 123.456 shares) from the shares purchased on 1/2/04." If you donate covered mutual fund shares, Vanguard will use your preferred lot identification method; if this is specific identification, you will have to include a similar letter because there is nowhere to select lots on the form. If you donate securities from your brokerage account, you can specify lots on the form itself, and you can use specific identification even if this is not your default method. (For example, you might want to sell shares automatically as highest-in-first-out, which usually minimizes taxes; when you donate, you would specify your lowest-basis shares.)
You cannot deduct the charitable contribution until the securities are transferred from your account; if you are donating mutual funds, you have to wait for the charity to fill out the paperwork after you send the form. Therefore, if you want to get a deduction on this year's taxes, don't make the contribution very late in the year. (In contrast, if you mail a check on December 31, it is deductible this year even if the charity deposits the check in January.)