A donor-advised fund is an investment account structured to help you optimize the way you donate to IRS-qualified charities. It offers the potential for valuable tax advantages, a streamlined donation process and a high degree of flexibility regarding what and when you give to charity.
What is a Donor-Advised Fund?
A donor-advised fund is a charitable investment account that optimizes the way individuals, families and organizations give to charities. Essentially, it is a feeder account that receives irrevocable contributions, invests them in a tax-free manner and grants them to handpicked charities on a timetable established by the donor.
A donor-advised fund can be used to support any IRS-qualified 501(c)(3) charitable organization, but it cannot be used to support political groups, crowdfunding campaigns, or private foundations. Money from donor-advised funds must be used for charitable giving.
There are a variety of organizations that sponsor donor-advised funds, including community-focused sponsors, which focus on local causes; single-issue sponsors, which typically support national and international charities focused on a particular issue or geographic region; and commercial sponsors, which are run by the nonprofit arms of national financial services firms, such as Charles Schwab, Fidelity and Vanguard.
Advantages of Donor-Advised Funds
Giving via a donor-advised fund can provide you with a number of meaningful advantages and wealth management. The most prominent benefits relate to taxes.
However, donor-advised funds also offer you the ability to streamline the donation process and increase your flexibility. Below, we expand on these ideas.
Giving in a Tax-Favored Manner
Like a traditional charitable contribution, the primary benefit of donating via a donor-advised fund is the ability to give in a tax-favored manner. While fulfilling its intended philanthropic purpose, a donation to a donor-advised fund can potentially lower your taxes in two ways.
- When you donate an appreciated asset, you can avoid paying the capital gains tax.
- If you itemize via Schedule A, you can deduct the value of the gift from your income taxes up to IRS-permitted limits.
Streamlined Donation Process
Instead of making one-off donations to multiple charities, you only make donations to the donor-advised fund, which has the resources and expertise to efficiently execute downstream contributions in accordance with your instructions all while addressing the associated compliance work. The process can greatly alleviate your administrative burden, which includes tax filings.
Flexibility To Donate Over Time
A donor-advised fund provides you flexibility when you’re not sure which charities should receive your donation or when you want the grants to occur. You can simply make a bulk donation to the donor-advised fund, take a tax deduction for the current year, and support your favorite charities over time.
There is no mandatory distribution date, which means contributed funds could remain in the donor-advised fund for years. However, some fund sponsors have policies that require regular charitable grants.
Flexibility To Donate a Variety of Assets
When it comes to charitable donations, most people automatically think about gifting cash. However, this isn’t your only option, and it’s often a suboptimal choice from a tax perspective.
Donor-advised funds can accept a wide variety of assets, including cash, publicly traded stocks and bonds, private equities, real estate, life insurance policies and cryptocurrencies. Moreover, they can harvest the more illiquid assets over time, facilitating downstream cash grants to charities that are unable to accept other assets.
Disadvantages of a Donor-Advised Fund
The advantages of donor-advised funds are clear, but as outlined below, these vehicles have some subtle drawbacks.
- While many donor-advised funds allow donors to direct downstream grants, payout decisions are ultimately made by the sponsor. In some rare situations, this can lead to unwanted outcomes.
- Commercial sponsors charge fees for their donor-advised funds. This can cut into the value of donations.
- There is some negative public sentiment regarding donor-advised funds. Critics claim the charitable nature of these organizations is often used as an optics scheme to divert attention from their primary purpose: enabling ultra-wealthy individuals and organizations to capture significant tax advantages.
How Does a Donor-Advised Fund Work?
The process of donating via a donor-advised fund begins with selecting a sponsor that can best help you achieve your philanthropic goals. If you’re passionate about local causes, a community-focused sponsor may be suitable.
If you want to focus on a particular national or international issue, a single-issue sponsor may be ideal.
Alternatively, if you have various charitable plans, you may want the control and flexibility offered by a commercial sponsor.
Once you select an appropriate sponsor, donating via a donor-advised fund is fairly straightforward.
- Make an irrevocable donation. Donate cash and other assets to be eligible for a tax deduction in the year of the gift.
- Invest your donation for tax-free growth. If you need time to decide which charities to support, you can invest donated funds (usually, in a strategy of your choice). Until you grant the funds to specified charities, they have the potential to grow tax-free, which increases the size of your charitable base.
- Support your charities. At any time, you can support virtually any IRS-qualified public charity. The fund sponsor will conduct due diligence to ensure your money only goes to qualified organizations. In many cases, the sponsor can also provide grant recommendations that align with your profile.
Important Tax Considerations for Filers with Itemized Deductions
Contributions to donor-advised funds are subject to the same IRS limits that govern contributions to traditional charitable organizations. In general, deduction limits are as follows:
- If you donate cash, the deduction is limited to 60 percent of your adjusted gross income (100 percent for 2020 as a result of the Cares Act).
- If you donate long-term appreciated assets, such as stocks, the deduction is limited to 30 percent of adjusted gross income. Excess amounts can be carried forward for five years.
- If you donate short-term appreciated assets, the deduction is limited to 50 percent of adjusted gross income. Excess amounts can be carried forward for five years.
Private Foundations vs. Donor-Advised Funds
Like donor-advised funds, private foundations are charitable giving vehicles. They facilitate philanthropic goals while providing tax advantages.
However, private foundations are subject to much more stringent tax laws and regulations than donor-advised funds. Moreover, while sponsors shoulder the tax compliance work for donor-advised funds, private foundations must complete tax filings and recordkeeping on their own. The workload can be significant.
Private foundations are clearly at a disadvantage to donor-advised funds with regard to tax treatment and compliance work, but they have their advantages.
Most notably, they have greater administrative control over the assets they hold and more flexibility for making grants. This includes the ability to give money to organizations other than IRS-qualified 501(c)(3) charities.
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- Internal Revenue Service. (2021, August 23). About Schedule A (Form 1040), Itemized Deductions. Retrieved from https://www.irs.gov/forms-pubs/about-schedule-a-form-1040
- Internal Revenue Service. (2021, August 18). Charitable Contribution Deductions. Retrieved from https://www.irs.gov/charities-non-profits/charitable-organizations/charitable-contribution-deductions