When it comes to making a meaningful impact with your wealth, there are a variety of vehicles and planning strategies to consider. One of those is a Donor-Advised-Fund or DAF. As advisors, we often recommend this vehicle to those who know they want to be charitable but aren't sure about the specifics. They are also typically in a financial situation where targeted giving in a specific time frame could have significant tax benefits.
How It Works
A Donor-Advised-Fund is similar to a family foundation in several ways, but with a simple structure and fewer administrative complexities. Donors first need to open a DAF account through a qualified provider. The account is then funded through contributions of either cash or investments. Once the contribution is processed, the funds are considered donated. At this point, they cease to belong to the individual or entity donating them and become the fund's property. Donors, however, retain authority over the fund and dictate how it is invested. They also can make grant "recommendations" to qualified 501c3 charities. This lets account owner(s) claim a charitable deduction at a time that is convenient for them, all while deferring when they want the funds to go to the charity of their choice until a time that is also convenient.
For example, let’s assume that you typically donate about $30,000 yearly – just slightly above the standard deduction for a married filing jointly household. You will likely itemize each year and take that $30k as a deduction. With this approach, you will take $60,000 in charitable deductions over two years. However, if you have the funds available, you might consider contributing $60,000 this year and taking the $60,000 deduction this year, and then skipping your donations next year and taking the standard deduction next year for a total of roughly $84,000 in deductions over the two years (note: this strategy only works if you aren’t taking any other deductions and wouldn’t itemize if not for the charitable deduction).
Let’s also say that while you can make a charitable contribution of that size all at once for tax purposes, you don’t want to make all of your gifts directly to charities at that time. With a DAF, you can spread out when the funds are disbursed to eligible charities, making those grants when you feel like it. What does this look like logistically? Glad you asked. First, you need to open a DAF. Second, you need to fund the DAF. This is the point at which you will take the charitable deduction – when the money is contributed to the DAF. You can do this in a couple of ways. One is simply to contribute cash to the DAF, deducting the amount of cash contributed when it enters the account. Alternatively, if you have securities that have appreciated significantly in value in taxable accounts, this is a great opportunity to wipe out some of those gains. In this instance, you would find a holding with a significant gain and donate whatever portion of that holding you’d like to the account. In doing so, you effectively donate the gains, and they cease being taxable. If you have cash on hand that you could have donated instead, you could purchase back that holding at roughly the same price (it may fluctuate between when you donate the holding and when you buy it back). This leaves you in roughly the same position but with a holding that no longer has the capital gains.
Once the holding enters the account, it will likely be sold (at no gain to you) and reinvested in the fund's strategy. For smaller DAFs, investment strategies are often limited to a few choices dictated by the custodian you chose when the account was created. For example, you may invest the account in a conservative or growth strategy, depending on what the platform offers. When you decide to make a grant with the funds, the fund manager will sell some of the holdings they have invested the account in and deliver your grant in cash to the organization you recommended. It's important to remember that you will not get a deduction when the grant occurs because you already took it when you contributed to the DAF. While the logistics vary from platform to platform, this is commonly how contributions, investing, and grants are carried out, but you’ll want to confirm with your provider to be sure.
The Benefits of a DAF
Arguably the most significant benefit of a DAF is its added flexibility at a lower administrative cost. For individuals looking to leave a substantial impact, it may make sense to double up their charitable donations so that they can maximize their deductions. To do so, one would lump several years' worth of giving into one year and then take the standard deduction for the other years (assuming they have no other deductions to claim). This can lead to significant tax savings when executed well.
Another great benefit of DAFs is the ability to donate appreciated assets and avoid recognizing capital gains. When given the option of donating an appreciated asset or cash of the same value, it is usually prudent to donate the asset. As I shared prior, a donor can then take their cash and buy back the asset, leaving them in the same position investment-wise but effectively eliminating the existing gain on the position. This is a highly effective way for charitably minded individuals to access after-tax funds without incurring significant gains and paying those capital gains taxes.
The Drawbacks of a DAF
Of course, as with many financial planning vehicles, there can be drawbacks. One such limitation is the availability of investments. Many DAFs are run by large financial institutions such as Charles Schwab or Fidelity. Their programs typically limit your investment options to a handful of available strategies, mainly if your DAF is not very large. At more significant account balances, investors may have the potential to work with an advisor and implement a broader trading strategy.
Another limitation of a DAF is that you may only make grants to eligible 501c3 charities. Grants cannot be made to individuals, but must be made to registered organizations (though you may have the option of specifying how you'd prefer the funds be used).
Finally, once the funds have been contributed to the account, they are no longer yours and cannot be returned to you. They may stay in the account for as long as you like (though that rule could change down the road).
While there are some limitations to a DAF, there are also many great qualities that have the potential to help take your dollar further when it comes to your charitable legacy. If you'd like to explore whether or not a DAF is right for you and how it might integrate with the rest of your financial plan, we invite you to schedule a call with us. We'd be happy to perform that analysis for you.