Note: This article is part of Morningstar's November 2016 Year-End Tax-Planning Guide special report. A version of this article appeared Dec. 24, 2015.
Question: What is a donor-advised fund? Should I be using one instead of donating to charity directly? Answer: It depends. Donor-advised funds can offer some advantages over donating cash directly, but it's a good idea to weigh their pros and cons before deciding if they make sense for you. What Is a Donor-Advised Fund? Donor-advised funds have become increasingly popular in recent years--as measured by both the number of accounts and the account size, according to data from the National Philanthropic Trust. Donor-advised funds are investment vehicles administered by public charities; for example, Fidelity Charitable administers a donor-advised fund for Fidelity, Schwab Charitable administers the Schwab Charitable Fund, and Vanguard Charitable administers a donor-advised fund for Vanguard. (National and local organizations not connected with financial institutions also administer donor-advised funds; these funds are often set up to benefit a specific charity or region.)
Benefits Immediate tax benefits, payout flexibility Perhaps the biggest advantage is the ability to make donations to the account and receive immediate tax benefits for doing so while being allowed to disburse the money from the accounts according to your own timetable. In other words, you can choose to pay out a donation to an approved charity right away, or invest the money in the donor-advised fund account and let it grow tax-free until you want to pay it out; either way, you get an immediate tax deduction. At the same time, you retain advisory privileges over how the account is invested, and how the fund distributes money to charities.
In this way, donor-advised funds can offer some advantages over direct donations to charity from a flexibility and strategic tax-planning perspective. For example, let's say you have a higher-than-usual adjusted gross income in a certain year because you exercised some employee stock options or got a big cash bonus. Contributing to a donor-advised fund allows you to increase your tax deduction to help offset your higher tax burden in that calendar year--you can take an income tax deduction of up to 50% of your AGI for cash contributions. And the option to invest the assets instead of immediately disbursing them gives you a little more time to research charities and decide how best to allocate your donation.
Donating securities in-kind can minimize your tax burden, maximize your donation
Another benefit is that, unlike some small charities, donor-advised funds can accept donations of appreciated securities (held for more than a year) at fair market value, not your original cost basis. This allows you to maximize your charitable donation: If you sold the securities, you would have to pay capital gains taxes (generally 15% for most tax brackets, but it can be as high as 20% for the highest tax bracket), which would reduce your overall contribution amount.
Say, for example, you donate $20,000 in
Donating in-kind could also be an effective tool for rebalancing your portfolio, as it may allow you to reduce an overweight in your portfolio (such as a big position in Apple, in the example above) without paying taxes on the sale of the security. As far as tax considerations, donors may be eligible to take a tax deduction of up to 30% of their AGI for contributions of stocks, mutual fund shares, real estate, or other assets (check with each donor-advised fund for a list of the asset types accepted).
Administrative convenience A donor-advised fund can help with recordkeeping, too, because even if you donate to multiple charities in a calendar year, the donor-advised fund consolidates the receipts you would file with the IRS into one statement and one deduction amount.
In addition, the donor-advised fund takes care of doing due diligence on the charities you recommend to receive a donation. If you were to make a direct charitable contribution, the onus would be on you to check and make sure the charity is eligible to receive tax-deductible charitable contributions per the IRS. (As an aside, this tool on the IRS' website can facilitate that task.)
Drawbacks You cede control of the assets One of the drawbacks is that although a donor-advised fund allows the assets to be invested and grow in an account tax-free, because you get an immediate tax benefit for the contributions you make, they are irrevocable. (That means you can't get them back, for any reason.) In addition, although you can make recommendations about which charities you want the funds to be distributed to, you don't have ultimate say over this. (In practice, however, it seems that most sponsors of donor-advised funds will act in accordance with your recommendations, provided your selected recipient is an eligible charity.)
The money doesn't have go to charity right away The donation you make can sit in the donor-advised fund account indefinitely. In fact, you can pass it along to your heirs. Some critics of donor-advised funds consider this a negative, because the money held in the account is not going to charitable causes that could benefit from the donations now.
There are minimums and fees There is a minimum donation level required to set up an account: In the case of Fidelity and Schwab, it's $5,000, but Vanguard Charitable requires a $25,000 initial contribution. Also, investors in donor-advised funds pay annual administrative fees on account balances--for the Fidelity, Vanguard, and Schwab Charitable donor-advised funds, this is 0.6%; Vanguard and Schwab give expense breaks on balances greater than $500,000. And investors also pay fees on the underlying investments (trading commissions on stocks and bonds, and operating expenses for mutual funds). Though not typically onerous, all of these fees eat away at the overall charitable donation, and direct investments to charity would not face the same fee burden.
There are also minimum amounts for grants to charities--sometimes as little as $50 (Fidelity and Schwab), other times $500 (Vanguard).
You may not like the underlying investment options Although in many cases you can choose the allocation style--in other words, whether the account is invested more conservatively or more aggressively, you generally have to choose from a preselected menu of investment options, some of which may be subpar. It pays to do your homework here before selecting a donor-advised fund.
Summing Up Whether or not a donor-advised fund makes sense for you will depend on your personal situation. If you want to donate smaller amounts in cash--say, less than $5,000 (the minimum contribution at some donor-advised funds)--and you know exactly which charities you want to donate to, it may make more sense to donate directly than to set up a donor-advised fund account because of the fees associated with them.
But a donor-advised fund account may make sense for you if you want to make a larger charitable donation in a calendar year but defer the payout--perhaps because you want to invest and grow the balance or because you have yet to choose the recipients. It may also be a tax-efficient choice if you want to make an in-kind donation of appreciated securities or other asset types that smaller charitable organizations are not equipped to accept.