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Our Advice on Donor-Advised Funds

Susan Dziubinski: I'm Susan Dziubinski with Morningstar. The Biden administration's proposed tax law changes includes a proposal to limit the step-up in basis for inherited assets. And that's leading some investors to consider donor-advised funds. Joining me today to discuss what donor-advised funds are and how to determine if they're a good fit for you is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Hi, Amy, thank you for being here today.

Amy Arnott: Great to be here.

Dziubinski: Let's start out at the beginning with the basics. How do donor-advised funds work?

Arnott: Donor-advised funds are public charities. They're qualified charitable organizations that allow you to make a charitable donation and take an upfront tax deduction but keep the assets in sort of a holding zone as you make grants to charities over time. So that means the assets benefit from tax-free growth. And they're called donor-advised funds because the donor has an advisory role in deciding which grants to make and how to invest the underlying assets.

Dziubinski: Then who should perhaps consider a donor-advised fund from a tax perspective? Arnott: Since the tax law changes a couple years ago, there's now a higher threshold for itemized deductions. So if you're trying to get over that threshold, it could be helpful to bunch donations, which means making a larger donation in a single year instead of smaller annual donations that might not be tax-deductible. And donor-advised funds can also be valuable for investors who might have a concentrated position and a highly appreciated asset like company stock or another asset that you've held for a long time. So when you donate an appreciated stock or another type of asset, you get the up-front tax deduction. And you can also reduce the risk of having that concentrated position in your portfolio without taking the tax hit from realizing capital gains.

Dziubinski: What are some of the advantages in general of donor-advised funds?

Arnott: As I mentioned, the up-front tax deduction is one of the main advantages. You can deduct up to 60% of your adjusted gross income for a cash donation or up to 30% for in-kind donations if you contribute another type of asset like a stock, a mutual fund, a business interest, or real estate. And as a donor, you can also help decide when and where to make charitable grants as long as they're going to a qualified charitable organization. So you can make grants all at once or make them over time. And as I mentioned before the assets can benefit from tax-free growth.

Dziubinski: Then what would the limitations be of these vehicles?

Arnott: The biggest thing to keep in mind is that once you make a contribution to a donor-advised fund, it's irrevocable, so you can't get your money back if you change your mind or suddenly find yourself in a financial pinch. These funds also come with an additional layer of fees in addition to the cost of the underlying investments. The administrative fees start at about 60 basis points for smaller accounts. So it's not as cost-effective as donating to a charity directly. And another important thing to note is that the account administrator has to approve every grant. So there might be a time lag of maybe a week or two before the money actually gets sent to the charity you're recommending.

Dziubinski: So, Amy, you've recently taken a deep dive into three of the largest donor-advised funds from Schwab, Fidelity, and Vanguard. How do they stack up against each other or compare?

Arnott: They're pretty similar overall. Fidelity and Schwab are the most accessible for smaller donors because they don't have a minimum contribution amount. Vanguard has a $25,000 minimum for initial contributions and $5,000 for additional contributions. But it also charges lower fees for higher account balances. And all three of these major donor-advised funds have a pretty broad range of investment options, so you can either invest in a preset diversified portfolio with a specific risk level or in single-asset funds that you can use as building blocks to put together your own portfolio.

Dziubinski: Based on sort of the entire package of each of these from Fidelity, Vanguard, and Schwab--taking into account costs, investment variety, investment minimums--is there one that sort of stands out?

Arnott: Yeah, if you can afford the $25,000 minimum, Vanguard's donor-advised fund is probably the best option. It has the lowest costs and the strongest investment lineup. But Fidelity and Schwab are decent options, too, so if you already have an account with one of those firms, it can be easier to set up a donor-advised fund under the same umbrella.

Dziubinski: Amy, thank you so much for your time today and this great overview. We appreciate it.

Arnott: Thanks, Susan. It was nice talking with you.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.

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