How do donor advised funds work?

For those looking to amplify their philanthropic impact, donor advised funds, or DAFs, are an increasingly popular option thanks to their flexibility, low administration costs and streamlined giving process.

While they're often a tax-savvy way to maximize charitable giving efforts, there are several factors to consider before moving forward with this type of fund. Learn more about the benefits of DAFs and how they can aid in your charitable planning goals.

What is a donor advised fund?

A donor advised fund is a charitable giving vehicle that allows individuals, families and businesses to make tax-deductible contributions to a sponsoring organization—typically a community foundation or other nonprofit organization.

Donors can contribute cash, stocks or other assets and receive a tax deduction during the tax year the assets are contributed to the fund. Contributions can be invested until the donor requests that a grant be made to an IRS-qualified charity of their choice.

The benefits of donor advised funds

Donor advised funds offer advantages for tax planning and charitable giving. Donors can contribute during high-income years to maximize tax deductions, then make grant recommendations to qualified charities when they're ready. This timing flexibility allows for sophisticated philanthropic planning strategies.

The ability to maximize tax deductions with the timing flexibility of charitable distributions is a key advantage, but these funds offer a range of other benefits. More specifically, they:

• Allow for anonymous giving
• Act as a conduit for donating appreciated securities to charities that might not otherwise be able to manage this type of donation directly
• Give family members an opportunity to engage in philanthropic decision-making
• Simplify the establishment of a charitable legacy after death because DAFs can be the beneficiaries of IRAs, wills and trusts
• Allow for more strategic evaluation of recipient charities' stewardship of funds over time
• Help with estate tax liability reduction because contributions are removed from the donor's taxable estate

Given the range of benefits they offer, DAFs have become attractive vehicles for charitable giving. However, there are several potential issues to be aware of when considering this option.

What are the disadvantages of donor advised funds?

Although the benefits are enticing, it's important to understand the issues that may arise before adding a DAF to your charitable giving strategy. Here are some common concerns.

• Delayed charitable impact: Although donors receive tax deductions at the time of their contributions, there's the potential for an indefinite delay in the distribution of funds from the DAF to the charity because there are no distribution requirements. Any delays of fund distributions may diminish the potential impact of your gift.
• Loss of direct control: When donors contribute, the sponsoring organization technically owns and controls the assets. While donors can recommend grants, the sponsor has final approval and may decline recommendations that are controversial or misaligned with its mission. For instance, if a donor recommends a grant to a nonprofit engaged in partisan political activity, the DAF sponsor may decline the request because it conflicts with the organization's mission and IRS rules. In practice, this isn't typically an issue because most sponsors have broad missions, although it can feel like a loss of control for some donors once their assets are in the fund.
• Regulatory developments and proposed legislation: There are ongoing legislative discussions and proposals that seek to increase DAF transparency, add minimum distribution requirements and prevent abuse.

Discuss these topics with your advisor so you can weigh the risks against the benefits and understand if a particular policy or process doesn't align with your charitable gift plans.

What types of assets can you contribute to donor advised funds?

One strength of DAFs is their ability to accept a diverse range of contribution types. Although the specific asset classes vary, there are several types of commonly accepted asset classes.

• Cash: Cash contributions to DAFs give donors immediate tax benefits by lowering their taxable income during the year of their contributions on a per-dollar basis up to 60% of adjusted gross income, or AGI.
• Appreciated securities: Contributing assets like stocks that are held for over a year allows donors to avoid capital gains tax for the market value of the donations. Appreciated assets can be deducted up to 30% of AGI, with the potential for excesses to be carried forward up to 5 years.
• Real estate and complex assets: DAFs can accept illiquid assets like real estate, and sponsors have the capacity to access and liquidate these complex asset types—providing donors with another avenue for substantial tax deductions.
• Cryptocurrency and alternative investments: Similar to stock contributions, classes like appreciated assets, cryptocurrency and alternative investments allow donors to potentially eliminate capital gains tax while making fair-market-value deductions for their contributions.
• Retirement account and insurance policy beneficiaries: Donors can make a DAF the beneficiary of their retirement accounts or life insurance, allowing their charitable legacy to be carried on long after their death.
• Business interests and private equity: Contributing business interests and private equity fund interests also offers donors substantial tax deductions and capital gains avoidance. These types of contributions require preapproval and due diligence from sponsors and advanced cash donations to cover added administrative expenses.

While noncash assets often offer the most significant tax benefits, each sponsor will have unique policies dictating what asset types are accepted. Be sure to check with your preferred DAF to understand the assets you can contribute.

Donor advised funds tax deductions

Contributions qualify as gifts to 501(c)(3) charities, with deductions equal to the fair market value of contributed assets. Tax-deduction limits vary based on asset type and AGI, with 5-year carry-forward provisions for contributions exceeding annual limits.

• Cash only: Tax deduction up to 60% of AGI
• Cash and appreciated property: Tax deduction up to 50% of AGI
• Long-term capital gains assets: Tax deduction up to 30% of AGI

Differences between DAFs and private foundations

A private foundation is a nonprofit entity set up for charitable purposes. Unlike a public charity, a foundation doesn't engage in fundraising. Instead, it's funded by an individual, company, family or other group of like-minded individuals. This is one aspect that makes foundations similar to DAFs, but there are a few key differences.

For one, foundations can be expensive to set up and maintain—with ongoing legal and tax reporting requirements. DAFs typically have lower startup costs and fewer ongoing administration expenses than private foundations. They also receive more favorable tax treatment than private foundations, which carry a limit of 30% of AGI for cash contributions and 20% of AGI for donating appreciated property.

What are the costs and fees for donor advised funds?

Expenses are essentially comprised of two unique costs: administrative fees and investment management fees. Although the costs are significantly lower than those to administer a private foundation, it's critical to fully understand the fee structure to maximize the impact your gift will ultimately have on your chosen charities.

• Administrative fees: Administrative fees cover the operations of the funds and include processing grants and offering support to donors. They typically range from 0.6% to 1.0% annually and often offer lower rates as account balances increase.
• Investment management fees: These fees also vary by provider as well as the size of the fund and are based on the underlying mutual fund's expense ratios.

Although the initial fee percentages are small, their long-term impact on your giving capacity is an important consideration. For example, the combination of administrative and investment management fees—even when they're less than 1%—can add up over the course of 20 years. The percentage impact is more significant with a small account compared to a large account that would likely have reduced fees.

Take the time to shop for a DAF provider with reasonable fees to make the most of the compounding effect of your contributions as they grow in a tax-free environment over the long term.

One of many charitable-giving strategies

DAFs complement other philanthropic vehicles, including charitable gift annuities, charitable remainder trusts and private foundations. Each option offers distinct advantages for estate planning, tax optimization and charitable legacy creation. Consider collective charitable giving strategies like giving circles for amplified impact.

Financial advisors specializing in philanthropic planning can help you evaluate whether this type of fund aligns with your charitable objectives and tax situation. Professional guidance ensures optimal integration of DAF strategies with your overall financial and estate planning goals.

The bottom line

Given the tax advantages and flexibility they offer, donor advised funds can help you get the most from your charitable gifts. The wide range of assets allowed in a DAF, coupled with low administration costs, can help you build a more robust philanthropic legacy.

Key takeaways

• Donor advised funds have become a popular way to amplify your charitable giving plans thanks to their flexibility, low administration costs and streamlined processes.
• In addition to cash, DAFs allow you to donate a wide range of assets, such as real estate, cryptocurrency, appreciated securities and business interests—many of which include significant tax and capital gains advantages.
• Costs to administer DAFs are generally lower than those of private foundations. They don't have substantial startup costs, but they do involve administrative and investment fees calculated as a percentage of the account balance.