How to Use Donor Advised Funds
Donor advised funds are a useful tool for charitable giving, especially in years where a reduction in adjusted gross income would be helpful. Donor advised fund owners can control the distribution of gifts from the account while enjoying the full deduction value of the contribution in the year that it is made.
A donor advised fund (DAF) is a charitable financial instrument managed by a custodian on behalf of a person, family, or organization.
We cover them briefly in Milestone 9 of the Next Dollar Roadmap.
A donor advised fund allows the contributor(s) to immediately recognize any tax deductions for the whole amount of a donation, but control its distribution over an extended period with no time limit.
Donor advised fund owners can deduct up to 60% of their adjusted gross income (AGI) for cash contributions and 30% of their AGI for donating appreciated securities.
Contributions to a donor advised fund are held by a 3rd party custodian who then distributes the funds according to the instructions of the fund owner(s).
Most of the larger investment houses have services for establishing donor advised funds, but Fidelity is known for having one of the most flexible and user-friendly donor advised fund programs.
Gifts can be made at one time or on a recurring basis. The donations are immediately tax deductible and irrevocable, meaning they can never be taken back by the contributor.
Once the assets are in the account the account owner maintains control over how they are invested and distributed.
Average J’s DAF
For example, let’s assume Average J opens a donor advised fund at Fidelity and deposits $10,000 into the account.
Average J can deduct that $10,000 from his or her taxes in the year of the contribution but doesn’t have to donate any of that amount right away.
In fact, there’s no IRS requirement that Average J ever direct the money to an actual charity. It can sit there indefinitely.
If the money is still in the account at Average J’s death, he or she can have the balance sent to a charity of choice or name a new administrator who can decide what to do with the money.
In this example, let’s assume Average J made the contribution on his or her 30th birthday but decides to wait 20 years to give the sum to charity.
If the contribution earns 10.39% interest over that span, it will be worth $72,210 when finally donated to charity.
Average J’s tax deduction would still only be based on the $10,000 contribution even if the charity receives the whole $72,210.
You may be asking yourself why anyone would wait years to redirect their donation to an actual charity.
Honestly, I don’t have an answer to that unless they just really want to let it grow.
What I can understand is putting a large sum of money into a donor advised fund in a single year in order to reduce a high adjusted gross income and, thus, reduce one’s income tax liability.
If you found yourself in just such a situation but didn’t want to give it all to a charity or charities at one time, then a DAF could be a useful tool for you.
Donor advised funds also provide an opportunity to take advantage of historically high standard deduction rates. Let’s see how in another example.
Terry & Tom Tither
As we touched on previously, the tax benefits of a donor advised fund are similar to just donating appreciated assets directly, but the DAF route does allow you to concentrate the tax deduction in one year while distributing the assets across whatever period you prefer.
Let’s look at an example to see how this might be beneficial.
Terry & Tom Tither have been giving 10% of their income to their church for as long as they can remember, and intend to continue doing so until they pass away.
Over the years, the Tithers have accumulated quite a sum of assets in a taxable brokerage account and would like to begin donating appreciated shares to their church.
Their annual AGI in 2023 is $150,000 which puts them well into the 22% tax bracket for a married couple filing jointly.
Their annual tithe of $15,000 is technically deductible, but since the donation is lower than the standard deduction of $27,700 they normally just go with it instead.
One day, the Tither’s stumble upon martinmoney.com and learn about donor advised funds.
After doing some math, the Tithers realize they can donate $45,000 of mutual funds from their taxable brokerage this year to reduce their AGI and claim a larger deduction. This is 3 years of tithing claimed all in one tax year, reducing their AGI to $105,000.
In the following two years, the Tither’s don’t get a deduction for their tithe since it has already been claimed. Instead, they use the standard deduction of $27,700 each year to reduce their taxable income. So, for this three-year period, here is what the Tither’s two options were:
Non-DAF Route | DAF Route | |
Year 1 AGI | $132,300 | $105,000 |
Year 2 AGI | $132,300 | $132,300 |
Year 3 AGI | $132,300 | $132,300 |
In this case, by using the donor advised fund, the Tithers save $27,300 ($132,300-$105,000) in taxable income for one year. This amounts to $6,006.00 back in their pockets in the 22% bracket.
As you might have guessed, the higher your bracket, the greater the savings, but it will only be true when there’s an arbitrage opportunity between the standard deduction and the amount you itemize.
For example, if it’s advantageous for you to itemize because of other deductions, the math for this might not make since.
When in doubt, just run the numbers. It’s not too complicated sconce the deduction will be calculated at your marginal tax rate.
Clearly, donor advised funds can provide great tax planning flexibility depending on your individual circumstances. Keep these in mind as you think about your charitable giving.
Other important points:
- In addition to cash and securities, most donor advised funds can accept less common assets like insurance policies, bitcoin, restricted stock, or even S&C Corp stocks.
- Some companies will charge a fee for managing your donor advised fund.
- The fund manager also technically has control over the distribution of money. You might want to do your homework to see how satisfied previous customers are with the service or start with a small donation and work up from there.
- Did I mention the contributions are irrevocable? Seems important.
