The Complete Guide to Donor-Advised Funds

For high-income individuals, donor-advised funds (DAFs) are becoming an increasingly popular giving and tax planning strategy. Indeed, DAFs have grown considerably in recent years. According to a report from National Philanthropic Trust, grants to DAFs rose by 27% between 2019 and 2020, the highest rate of growth in over a decade.

Yet despite their recent rise in popularity, many investors are unfamiliar with DAFs and their potential benefits and drawbacks. In this article, we’re sharing what you need to know about donor-advised funds and how contributing to a DAF may help you reach your financial goals.

What Is a Donor-Advised Fund?

A donor-advised fund (DAF) is a registered 501(c)(3) organization that can accept donations of cash, appreciated securities, and/or other assets. DAF donations are put in an account in the donor’s name. The DAF sponsor then helps direct the assets to a charity of the donor’s choosing.

With a DAF, the donor typically retains a significant amount of control over their charitable donations. However, legally, the DAF sponsor has the final say on how and when funds are dispersed.

When Should You Consider a DAF?

Like most financial planning strategies, donor-advised funds aren’t for everyone. If you already have a specific charity in mind, or you’d prefer to make smaller cash donations, you may want to consider donating directly to your preferred charities.

On the other hand, DAFs can be ideal for donors who:

  • Wish to donate larger amounts
  • Don’t know which recipients you wish to support
  • Have an interest in the tax benefit of DAFs

Additionally, smaller charities aren’t always equipped to accept the donation of appreciated stock and other assets. If you prefer to make non-cash donations, DAFs tend to offer more flexibility.

Benefits of Donor-Advised Funds

From a financial planning perspective, the primary benefit of donor-advised funds is tax efficiency. Indeed, DAFs can be especially useful in high-income years to offset taxable earnings. As a donor, you can take a taxable deduction in the year you make the donation, even if it takes years for the DAF to disperse the donation to charity. This allows you to enjoy the tax benefit immediately and decide which charity to support later.

Furthermore, if you donate non-cash assets like highly appreciated stock, you’ll avoid paying the capital gains tax you’d incur if you sold the stock yourself. In addition, you can take an immediate deduction for the full value of the donation (subject to IRS limits).

Lastly, donor-advised funds offer increased flexibility when it comes to the types of assets you can donate. In addition to cash, donors can contribute a wide range of appreciated assets, including stocks, bonds, mutual funds, privately held business interests, restricted stock, and even bitcoin and other cryptocurrencies.

Drawbacks of Donor-Advised Funds

Despite their benefits, DAFs also have potential drawbacks. For example, while you have control over how your account is managed, your DAF sponsor ultimately determines which charities receive your funds. If you want full discretion over your charitable donations, you may want to consider other philanthropic options.

In addition, there’s no requirement as to when the money in the DAF is dispersed to charity. Theoretically, these funds can sit in the fund indefinitely, which defeats the charitable purpose of the fund. For this reason, some particularly wealthy families may decide that setting up a private foundation to achieve their philanthropic goals makes more sense.

Finally, DAFs often have fees and minimum donation requirements, which can make them inaccessible to some investors. Meanwhile, private charities typically don’t have such requirements.

How to Choose a DAF

If you’re considering a donor-advised fund, one option is to work with your local community foundation. Currently, there are over 750 community foundations throughout the U.S. that sponsor DAFs. This number is even higher if you include faith-based organizations.

The primary benefit of working with a community foundation is that your funds often support local causes. As such, the staff may be more knowledgeable about the needs of the surrounding community. On the other hand, DAFs offered by large brokerage firms like Schwab, Fidelity, or Vanguard may be more accessible to the average investor.

Whether you prefer to work with a community foundation or financial institution, there are certain questions you should ask before choosing a donor-advised fund. For example:

  • What are the minimum investment requirements and upfront brokerage fees?
  • Are there ongoing administration fees?
  • What are my investment options?
  • How much control do I really have over where my donations go?
  • Are there charities that I would prefer to invest in directly?

This approach likely means you’ll have to do some research before making a final decision. Alternatively, a trusted financial advisor can help you determine which DAF makes most sense for you within the context of your financial plan.

Using DAFs Strategically

Indeed, donor-advised funds can be an efficient way to achieve your philanthropic goals. However, DAFs can also provide opportunities to meaningfully reduce your tax liability relative to other giving strategies.

For example, if you plan to donate $10,000 each year to your favorite charitable organization, it may be more beneficial to take the standard deduction when you file your taxes. In 2022, the standard deduction amount is $12,950 for single filers and $25,900 for joint filers.

On the other hand, you can front-load a donation of $50,000 to a donor-advised fund and request that the DAF distribute funds to your chosen charity each year for five years. In year one, you can receive a more favorable tax break by itemizing on your tax return. Meanwhile, you’ll still be meeting your charitable goals each year via the DAF. This strategy can be particularly beneficial in above-average income years.

Can a Donor-Advised Fund Help You Reach Your Goals?

If you’re charitably inclined and looking for an immediate tax benefit, a donor-advised fund can be an effective solution. This may be especially true if you have appreciated assets to donate, which smaller charities are typically less willing to accept. However, there may be more appropriate giving options for your goals and financial circumstances.

It’s important to weigh the benefits versus the potential drawbacks when considering any financial planning strategy. If you’re unsure if a DAF makes sense for you and would like to discuss your options with a trusted financial advisor, please schedule an introductory call. We’d be happy to hear from you.