Understanding Donor-Advised Funds: Pros and Cons

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A donor-advised fund (DAF) gives you an immediate tax deduction for charitable money you have not yet assigned to any charity. You contribute cash, stock or other assets to a sponsoring public charity, take the deduction in that tax year, and recommend grants to specific charities later, sometimes years later. The main cost is control. Once the gift is made it is irrevocable, the sponsor legally owns the assets, and you hold only advisory privileges. On top of that come fees and a set of grant rules that do not apply when you give directly.

What a donor-advised fund is

A DAF is an account held inside a sponsoring organization that is itself a 501(c)(3) public charity. Sponsors include the charitable arms of large brokerage firms, community foundations and some religious or cause-based charities. The account is opened in your name, or for a family or organization, but the assets belong to the sponsor from the moment you contribute.

The Pension Protection Act of 2006 gave DAFs a formal statutory definition: an account owned and controlled by a sponsor, separately identified by a donor’s contributions, over which the donor or the donor’s appointee has advisory privileges. The law also added excise taxes on prohibited grants and on grants that benefit donors.

How a DAF works

1. Open an account with a sponsor and name any successor advisors or charitable beneficiaries for the balance after your death.
2. Contribute assets. Cash, publicly traded securities and, at sponsors that accept them, assets such as private company stock or real estate.
3. Take the deduction in the year of the contribution, subject to IRS limits, by itemizing on Schedule A of Form 1040.
4. Invest the balance in the sponsor’s investment options.
5. Recommend grants to qualified charities whenever you choose. The sponsor reviews each recommendation and makes the grant.

Because the sponsor is a public charity, cash contributions fall under the higher public charity deduction limit (60% of adjusted gross income under current law), and contributions of long-term appreciated property are generally deductible at fair market value up to 30% of AGI. Amounts above those limits can be carried forward for up to five years. You need a written acknowledgment from the sponsor for any contribution of $250 or more, Form 8283 for noncash gifts over $500, and a qualified appraisal for most noncash property worth more than $5,000 (publicly traded securities are exempt from the appraisal rule).

Benefits of a donor-advised fund

Deduct now, decide later

This is the defining advantage. If you have an unusually high-income year, such as a business sale, a large bonus or a big capital gain, you can make several years’ worth of donations in that year and take the deduction when your tax rate is highest. The choice of charities can wait.

Giving appreciated assets without selling them

Many small charities cannot easily accept shares of stock. DAF sponsors are set up to receive securities and other assets and convert them to cash.

A hypothetical example shows the difference. Suppose you own stock worth $50,000 that you bought for $10,000 more than a year ago, and you want to give $50,000 of value to a local shelter that only takes cash. If you sell first, you realize a $40,000 long-term gain. At an assumed 15% federal rate, and ignoring state tax and the net investment income tax, that is $6,000 of tax, leaving $44,000 to give. If you transfer the shares to a DAF instead, there is no sale by you and no capital gains tax, and if you itemize you can generally deduct the full $50,000. The DAF then sells the shares and grants $50,000 to the shelter.

The holding period matters. Stock held one year or less is short-term property (see short-term vs. long-term capital gains), and the deduction is limited to your cost basis. A Fidelity Charitable study found that 76% of advisors’ clients used a DAF to donate appreciated assets.

Tax-free growth

Money invested in the account grows without tax on dividends, interest or gains. Any growth increases the amount available for grants, though it does not create an additional deduction for you.

Bunching to clear the standard deduction

Charitable gifts only reduce your taxable income if you itemize. Many households give steadily but never exceed the standard deduction, so the gifts produce no tax benefit. A DAF lets you combine, or “bunch,” several years of giving into one tax year, itemize in that year, and take the standard deduction in the others, while charities still receive grants on an even schedule.

Hypothetically, a married couple that gives $10,000 a year and has $20,000 of other itemized deductions would fall short of a $30,000 standard deduction every year. If they put $30,000 into a DAF in year one, they itemize $50,000 that year, take the standard deduction in years two and three, and keep granting $10,000 a year from the fund.

Simpler records and optional privacy

You keep one acknowledgment per contribution rather than receipts from every charity. Many sponsors also let you make grants anonymously, which can cut down on solicitations.

Downsides of DAF gifting

You give up legal control

A DAF agreement transfers ownership of the assets to the sponsor. You can recommend grants and investment choices, and sponsors generally follow those recommendations when the recipient is a qualified charity, but they are not legally bound to. The contribution cannot be reclaimed if your finances change.

The risk is not theoretical. The National Heritage Foundation went bankrupt in 2009 and its donor accounts were swept into the proceedings. The New York Times reported that about 9,000 funds worth a combined $25 million were wiped out. In another case, a sponsor used contributions to fund generous staff compensation, a golf tournament and legal fees in a lawsuit brought by an angry donor. In both instances courts upheld the sponsor’s right to use the donated money as it chose. Choosing a large, well-capitalized sponsor reduces this risk but does not change who legally owns the assets.

No payout requirement

Private foundations must distribute roughly 5% of their assets each year. Federal law sets no such minimum for donor-advised funds. Some sponsors have their own inactivity policies, but money can stay invested indefinitely. Critics argue this lets donors claim a tax benefit today for help that charities may not receive for years, if at all.

Fees

Sponsors charge an annual administrative fee, usually a percentage of the account balance with a minimum dollar amount, and the investment options carry their own expense ratios. As one example of the structure, Fidelity Charitable has charged the greater of $100 or 0.6% on the first $500,000 in an account, with sponsors also able to earn revenue from fees on the funds donors invest in. Critics compare this layering to 401(k) plans and argue that the financial firms running DAFs, along with wealthy donors, benefit more than charities do.

Restrictions on how grants are used

DAF grants must go to qualified charities and cannot provide more than an incidental benefit to you. In practice, that rules out using the fund to pay for gala tickets, the non-deductible part of a membership, school tuition, or anything else where you receive something in return. Grants to individuals are prohibited, as are certain grants to some supporting organizations. Violations can trigger excise taxes on the sponsor, the donor and the managers who approve the grant.

IRA charitable distributions cannot go to a DAF

If you are 70½ or older, a qualified charitable distribution (QCD) lets you send money from a traditional IRA directly to charity, excluding it from income and counting it toward required minimum distributions. QCDs cannot be made to donor-advised funds. For retirees who do not itemize, a QCD to an operating charity is often a better tax tool than a DAF contribution. The basics are covered in taxes on an IRA withdrawal.

DAF vs. private foundation vs. giving directly

Giving directly to a charity costs nothing extra and keeps every dollar with the recipient, but it offers no way to deduct now and decide later, and many charities cannot accept complex assets.

A private foundation gives you real control: you or your board decide on grants, can hire family members for legitimate roles and can make grants to individuals under IRS rules. In exchange, it must distribute about 5% a year, pays an excise tax on net investment income, files a public annual return, and gets lower deduction limits (30% of AGI for cash and 20% for appreciated stock). Setup and legal costs make foundations practical mainly for very large sums.

A DAF sits between the two: higher deduction limits and almost no administration, but advisory rights only.

When a donor-advised fund makes sense

A DAF fits best when several of these apply: you itemize or can itemize by bunching, you expect a high-income year, you hold long-term appreciated securities with a low cost basis, and you are comfortable with an irrevocable gift held by a third party. It fits poorly if you may need the money back, take the standard deduction regardless, want to use IRA distributions for giving, or want charities to receive funds right away.

FAQs

The Bottom Line

A donor-advised fund suits itemizers with a high-income year or low-basis long-term stock who accept that the sponsor will own the money permanently. Fees, grant restrictions and the loss of legal control are the price of deducting now and choosing charities later. Retirees who take the standard deduction, or donors who may need the money back, will often do better giving directly or using a qualified charitable distribution.