When the average person thinks of tax-advantaged accounts, they think of a 401(k) or an IRA. When the philanthropist thinks of one, they think of the Donor-Advised Fund.
Many people commonly misunderstand that they need to use a Donor-Advised Fund, or DAF, to donate in a tax-advantaged and meaningful way, but that is certainly not the case. DAFs do not always benefit you as the investor, or the charity itself. But for others, given certain financial circumstances or charitable preferences, they can be highly beneficial.
Most of the articles I see on DAFs are rather misleading when it comes to defining its true benefits. They tend to blow the tax benefits out of proportion, making the account seem more unique than it actually is. But with that said, DAFs are extremely beneficial. So I’m here to clean up the confusion and help you understand whether the benefits of a DAF outweigh the costs of using one.
But first, I want to lead with total transparency. I currently do not make use of a DAF. I do have a DAF just to understand the user experience, but I don’t contribute to it meaningfully. And that’s because at this point in my life, it doesn’t make much financial sense to make use of one. You’re now probably wondering…does it make sense for you?
In this 4-part series, I’ll:
Explain the basics of a DAF and how it works
Provide you with an easy way to determine whether or not a DAF is right for you
Compare various DAF providers (with a guest post written by Michael Dickens!)
Part 1 is a must for those of you less familiar with DAFs so that you can understand the fundamentals. Let’s begin!
The Donor-Advised Fund: In a nutshell
A DAF is a tax-advantaged investment account designed for giving to public charities. A DAF is like any other investment account in that you contribute money to it and then can invest those funds. But with this account, all distributions must go to a public, qualified charity. Contributions to a DAF are irrevocable, meaning you can’t go back on this decision and ask for your money back. You relinquish total ownership and control over those assets. This differs dramatically from other personal tax-advantaged accounts where you can get your money back, but you’d just face a penalty. In this case of DAFs though, the decision is done and final and you can no longer use this money for personal purposes.
Typically, DAFs are marketed as helping you with these four core things:
A DAF enables you to contribute a single, lump sum amount to the account, while allowing you to distribute this wealth to one or more charities over an extended period. By making a substantial lump sum donation within a year, you may be able to secure a tax deduction while also maintaining the ability to spread out your charitable contributions over time.
DAFs enable you to invest the money you plan to donate, meaning your charitable funds could grow exponentially beyond what you could donate in cash today
Capital gains, dividends, and interest are never taxed, and as such you are able to maximize your investments and impact to charity
DAFs make it relatively easy to automate your donations to multiple charities, reducing the time it would normally take to make multiple transactions and transfers
On the whole, a DAF is certainly a very powerful tool, but it’s crucial to note that you do not need to use a DAF to make tax-advantaged donations to charity. You also don’t need a DAF to invest funds that you intend to give to charity. We’ll debunk all these myths in the next part of this series, and we’ll talk about when and where it makes sense for you to actually use a DAF in the third part of this series.
Who manages a DAF?
There are three types of DAF “sponsors”:
Commercial Providers: Think financial services firms like Fidelity, Schwab, and Vanguard (the three banks we talk about frequently in the Learn to Invest course).
Community Foundations: Local organizations that provide a range of philanthropic services to a specific geographic area. Community foundations often offer DAFs as one of their giving options. The Cleveland Foundation is just one example.
Single-Issue Charities: Organizations that focus on a specific cause, and offer a DAF as a way for donors to support them. Universities, hospitals, faith-based organizations, and more might offer their own unique DAF.
In this series, we’ll be primarily focused on Commercial Providers, given they will typically have the most flexibility in terms of where and how one can donate.
How DAFs work
There are four steps that generally happen when you open and fund a DAF:
Donate: First, you will make your initial contribution or “donation” to the DAF. This can include cash, stocks, bonds or other eligible assets like real estate, life insurance policies, restricted stock units, cryptocurrency, and more. For the purpose of this series we are sticking to the basics like cash and funds because that is what most of us will be donating.
Choose: You'll designate the charit(ies) to receive your donations. Your DAF grants must go to a public, 501(c)(3) nonprofit organization. This is non-negotiable. You cannot use a DAF to support a private foundation, specific individuals, a political campaign, or an organization outside the US that doesn’t have a way of obtaining 501(c)(3) status, although many global organizations do find a workaround for this. It’s also important to note that not all public charities can or want to receive funds from a DAF. This is due to a variety of reasons: administrative and operational burdens, fees associated with processing funds, or charity policies that are not in line with those of your DAF. So you will want to be 100% sure your charity of choice can in fact receive funds from your DAF.
Invest: Your contributions to a DAF are typically invested, although this is not always required. Most providers have a set of funds from which you can choose your investment selection, but others allow you a bit more flexibility to choose individual stocks or ETFs. Typically the more money you invest in a DAF, the more control you have over your investment selection (more on this in a bit). Keep in mind that investing the funds in your DAF exposes your charitable donations to market fluctuations. While short-term market outcomes are hard to predict, long-term we expect the market to grow. So in theory, if you contribute to your DAF and let it grow over time, market growth will likely enable you to donate more than your original contribution in the future.
Grant: Generally speaking, DAFs allow you to donate to multiple charities, and they typically don’t limit the number of times you can make grants in a year. Sometimes, there may be restrictions on a minimum amount you can grant (e.g. you can’t donate less than $50 at one time), but you more or less have a lot of flexibility. One significant advantage of a DAF is the ability to establish your charitable goals all at once and automate the process. Rather than manually executing transactions for each charity, which can be overwhelming, a DAF lets you predefine the amounts and frequencies for distributions to multiple organizations. This simplifies the charitable process, especially if you're supporting numerous causes, saving you from the hassle of managing frequent transactions.
What can I invest in?
Your level of control over your investment selection will depend on the sponsoring organization. Ideally, the provider has a selection of broad-based index funds, similar to what we would recommend for any other investment accounts. But with DAFs, the fund selection is typically much more limited than the options you will find when investing your IRA.
Let’s take Fidelity’s DAF, Fidelity Charitable, as an example.
They have a number of investment options to choose from, but it’s fairly limited. Fidelity has over 10,000 options for their IRA, but only 25 options for their DAF! With that said, the fund options are still good. You can invest in Fidelity's Total Market Index Fund (FSKAX), with an expense ratio of 0.02%. But you can’t invest in Fidelity’s ZERO Total Market Index Fund (FZROX) that has a 0.00% expense ratio. In this instance, the difference in funds is negligible, but there are loads of DAF providers out there that are NOT like Fidelity and will only offer mutual funds with higher expense ratios. Remember, to check out Post #4 in this series for a comparison of providers.
A number of DAFs will give you much greater control over your investments, like the ability to choose specific stocks or ETFs, but only if you reach a minimum balance. For Fidelity, it’s $100,000. But this comes with another requirement, like working with a certified financial advisor. If you have $5 million with Fidelity, well then!, the world is your oyster and you can pretty much invest in what you want.
What other fees can I expect?
In addition to fund fees for each investment, most DAFs charge an administrative banking fee. In the case of Fidelity, they charge an annual administrative fee of 0.60% based on assets under management (AUM) or $100, whichever is greater. And then as your balance grows in your DAF, they will lower the fees based on tiers. This is just an example from one provider and the fees can vary substantially across providers.
What does DAF grantmaking look like?
With other tax-advantaged accounts, when you are ready to take the money out of the account (e.g. take a distribution), you’d sell some assets, turn those investments into cash, and then perhaps move it to your checking account for your use.
With DAFs, generally the grant you make is in the form of cash (although not always). Your provider is the one who will liquidate your investments and then make the grant to charity. As long as you designate your charitable beneficiaries up front and the cadence for which you want to make grants, then the actual work of doing the distributions is done for you.
What does this look like? Let’s say you contribute $20,000 this year to a DAF. You plan to make grants to a few charities totalling $5,000 each year. Without investing, you’d be able to make 4 donations annually before you run out of money ($5,000 x 4 = $20,000). But with investing, the value of your contributions change with market fluctuations. Take the example below. In this instance, you can actually donate more because the market overall grew with time.
Obviously this is a positive scenario where you end up being able to donate more money given market growth. But just to reiterate one more time, market growth is not guaranteed and you should still consider the risk of loss of capital.
DAF Pros & Cons
With that overview of DAFs, let me summarize the pros and cons.
Pros:
Tax Benefits: DAFs let you “front-load” contributions in a single tax year to get the tax benefit upfront, but then let you extend donations over a longer period of time. It’s the only account that lets you do this. DAFs also enable you to avoid capital gains tax and dividends and interest tax. But a reminder, tax breaks are not a unique feature of the DAF, and many other accounts let you optimize taxes. Make sure to check out the next post in this series on this very topic!
Simplified Giving: DAFs streamline charitable giving by allowing donors to make a single contribution and distribute funds to multiple charities over time. You are able to automate this process which is super helpful if you are donating to multiple charities each month.
Flexibility: Because of the extended timeline for donations, you can continue to research high-impact opportunities over time and change your donation strategy.
Investment Growth: DAF assets can be invested, potentially increasing the available funds for charitable giving over time. Again, this is not unique in that there are other accounts that allow you to invest and donate funds as well.
Cons:
Delayed Impact: Although contributions to your DAF happen immediately, your actual distribution of funds to charities may be delayed over time. This often means that charities that require immediate financial support to address pressing needs today face a delay in funding.
Fees: DAFs often have fees that can ultimately reduce the amount available for charitable grants. This is most obvious when you have fewer funds to select from, oftentimes with higher expense ratios, as well as general administrative fees to partake in the DAF.
Limits on Charities: There may be a high-impact opportunity you want to donate to, but if the organization does not have 501(c)(3) status, you will not be able to contribute to that cause.
Investment Risk: While investments can grow, they also carry the risk of loss. This is always something to be aware of when it comes to your personal wealth and making charitable grants.
Irrevocable Contributions: Once donations are made to a DAF, the funds cannot be retrieved for personal use. I generally don’t think of this as a con because the intention is to donate to charity after all. But if you do run into a large hardship and you need that money back, tough luck!
All right, that was a long overview, but I think we covered the most important bits. In the next section, we’ll talk about common misconceptions around the tax benefits of DAFs and begin to understand if and when a DAF is right for you!
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