Donor-Advised Funds
According to the National Philanthropic Trust, the first donor-advised funds (DAFs) were created in the 1930s, though only recognized formally in the tax code in the Pension Protection Act of 2006. In 2022, DAF owners contributed over $85 billion in assets and granted over $52 billion to non-profit organizations using nearly 2 million DAF accounts. Prominent investment companies such as Schwab, Fidelity, and Vanguard sponsor their own DAFs, helping drive adoption. You can learn more at https://www.schwabcharitable.org.
The tax code allows every individual to deduct nearly $15,000 and every married couple to deduct nearly $30,000 from their income before taxes start to apply, the “standard deduction.” Charitable contributions are considered deductible but only earn any practical value to the extent that they help drive a taxpayer’s total deductions over and above the standard deduction threshold. This incentivizes taxpayers to lump multiple years’ worth of charitable giving into a single tax year. Most years the taxpayers receive the standard deduction, but occasionally get a larger benefit during a higher giving year.
Enter donor-advised funds, which provide an opportunity to make an irrevocable charitable contribution, receive an immediate tax deduction, and then suggest grants from the fund over time. You can have it both ways: lump your contributions for tax purposes but smooth out your charitable giving. Donors have the flexibility to contribute to the fund as frequently as they want and can recommend grants to their preferred charitable organizations whenever they feel appropriate. Upon death, the donor can provide for one or more charities to inherit the DAF funds or provide an heir to take over as advisor to the fund. DAFs are not limited to just individuals. Families, companies, foundations, and other entities can use a DAF. A donor-advised fund could exist in perpetuity as successor advisors are, in turn, succeeded by latter successor advisors.
Donor-advised funds are similar to private foundations in many ways, but they offer a cheaper, more accessible alternative for the 99.5% of people who don't have the wealth or the energy to organize and administer their own foundations. DAFs also allow for anonymous grants if desired, while a private foundation must file annual reports that disclose members of the board, grant recipients, and other identifiable information that prevents them from remaining anonymous.
There are administrative advantages to using a DAF for charitable contributions versus the older approach of donating directly to charities. Record keeping is simplified using a DAF. Only donations to the DAF are important for tax purposes, rather than recording each donation to individual charities. Donors can direct grants via online tools or by writing checks to the charity directly from the DAF. The DAF will keep track of transactions over time, allowing donors to easily see the history of grants to their favorite charities.
A donor-advised fund may be part of a broader tax planning strategy. Several years of planned donations can be bunched into a single year, providing a valuable tool to help implement tax strategies. A prospective retiree may anticipate income to fall dramatically in retirement. Those final years of high income before retirement might be an opportunistic window to utilize a DAF to reduce income taxes. Contributing to a donor-advised fund may be beneficial anytime income is abnormally high, for reasons including the sale of a business, the receipt of equity compensation awards, windfall bonuses, or even Roth conversions. Combining DAF contributions with Roth conversions may allow for increased Roth conversions or can reduce the amount of liquid cash needed to pay the associated taxes of the Roth conversion.
In addition to increasing your itemized deductions, contributing to a donor-advised fund may provide other tax advantages. Many different types of assets can be used to fund a DAF, including highly-appreciated stock. This neutralizes the associated capital gains while still permitting the full deductibility of the appreciated stock value. The holding must qualify for long-term capital gains status. Other assets that can be used to fund a DAF include restricted stock, fine art/collectibles, private business interests, real estate, private equity, cryptocurrencies, equity compensation awards, and more. Please consult your tax advisor, as the rules can be nuanced, and every client's situation is different.
Donor-advised funds allow the donor to retain control over how and when the funds are distributed. These funds can remain invested for tax-free growth, allowing the donor to give more money to their favorite charities over time. By controlling the timing of the DAF contribution, donors can manage the timing of their tax deductions while planning for future grantmaking to qualified charities.
Provident can help clients who would like a professional to manage their DAF. There is no minimum to open a DAF through Schwab, but with assets greater than $100k, we can professionally manage the account using individual securities. The organization operating the DAF will typically charge fees. Schwab charges 0.6% of the balance annually to administer the DAF, plus investment-related expenses.
For charitably-minded individuals, a donor-advised fund may ease administrative duties and provide tax benefits. However, there is a cost of administering the fund and its related investments. DAFs are not suitable for everyone, but for many the benefits will outweigh the costs.
We believe that charity is good, and things that promote charity are good. Charity has benefits for the recipient and the donor alike. Donors can earn positive recognition–although many prefer to remain anonymous. They often build personal relationships with the recipient's stakeholders–its beneficiaries, its employees, and other donors. Donor-advised funds are helpful tools for pursuing worthy ends. Would you rather give more money to the IRS or to a charity of your choice?
Eric Wathen, CFA®