For those with a desire for philanthropy, you have a variety of ways to donate to charitable organizations. While the most common method is cash donations, the trend has been shifting toward donor-advised funds (DAFs), which allow you to donate to charity and receive an immediate tax deduction for doing so.

A donor-advised fund is an investment vehicle administered by a public charity. In addition to providing a charitable deduction, a DAF allows you to maintain control of how the funds are invested and when they are disbursed to your favorite charities.

DAFs gained mainstream popularity in the 1990s, and recent changes in tax laws—specifically, the 2017 Tax Cut and Jobs Act (TCJA)—have increased the appeal of donor-advised funds. Many philanthropically inclined taxpayers find themselves combining several years’ worth of charitable donations in the same year to push their total amount of itemized deductions above the standard deduction threshold.

The TCJA also made it so there is no overall limit on itemized deductions. Because of this, annual contributions and total assets held in donor-advised funds have more than doubled since 2014! It is important to note that cash contributions allow you to take an income tax deduction of up to 60% of your adjusted gross income (AGI).

Donor-advised funds follow a three-step process:

Contribute
Invest
Grant

This post will walk through these steps and describe who donor-advised funds might be best suited for.

Contribute

While cash donations are still common, non-cash contributions tend to be a more tax-efficient method. The list of non-cash assets continues to expand and includes real estate, privately held business interests, and fine art and collectibles. Donating highly appreciated assets allows you to donate more and pay less in taxes.

Example: Tom purchased $10,000 of Apple stock in 2013 at $15/share. His investment is now worth ~$80K!
- If Tom sells his shares and donates the proceeds to charity, he will owe long-term capital gains tax on the profit. This will amount to either 15% or 20% tax on the $70,000 gain.
- If Tom donates his shares to a donor-advised fund, he will not only avoid paying tax on the $70K but maintain control of how these funds are invested in a more diversified manner. He also controls when they are distributed to the charities of his choice.

Invest

Donor-advised funds provide a wide range of investment options, from mutual funds and exchange-traded funds (ETFs) to alternative investments (hedge funds and private equity). Each administrator offers a different set of investment offerings, which makes it important to research your options.

You can change the investment risk level and strategy as desired. If you plan to disburse funds in a shorter time frame, it is prudent to ensure they are invested in a lower-risk profile to help protect against market volatility.

Grant

The last step is granting money to charity. You can donate funds to any 501(c)(3) tax-exempt charity, and the minimum grant is typically $50. The grant process can usually be completed online.

With a DAF, you control when the money is distributed, which means you can allow the investments to grow long term. The longer the time frame, the bigger the potential impact of tax-free compounding growth.

While donor-advised funds provide many benefits, you should be aware of the drawbacks:

Control: Once a donation is made, it is irrevocable and permanent.
Fees: You face annual administrative costs along with the underlying investment fees.
Minimum donation: The minimum varies per administrator but is typically between $5,000 and $25,000.
Investment options: You typically select from a preset menu of investment options. While not necessarily a bad thing, it can feel restricting to some.

The Ideal Donor-Advised Fund Owner

Ideally, DAFs are best suited for those with highly appreciated securities who desire to make a large charitable contribution in a single calendar year and disburse the funds over time.

Doing so not only maximizes the immediate tax benefit but provides ample time for the funds to grow tax-free until you distribute them to your desired charities. Working with a fee-only, fiduciary financial planning firm can help identify whether this strategy is right for you.

Discuss your situation with a fee-only financial advisor.

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