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The Donor-Advised Fund Triple Play

The donor-advised fund (DAF) has been around for a long time but has surged in popularity and use since the mutual fund family Fidelity Investments made them easy to set up and use at a reasonable cost in 1991. As reported by The Chronicle of Philanthropy, the Fidelity DAF has become the most successful fundraiser in the United States and is second only to the Bill and Melinda Gates Foundation in grantmaking.

The first donor-advised funds were created in the 1930s as community foundations, but Congress did not create the tax structure for them until 1969. According to a 2016 report issued by National Philanthropic Trust, grants from donor-advised funds totaled $14.52 billion in 2015 and contributions in 2015 totaled $22.26 billion; the percentage of total charitable giving represented by DAFs keeps increasing year after year.

What Are Donor-Advised Funds and How Do They Work?

Think of a DAF as a personal charitable giving account. Once you make a gift to a DAF it is irrevocably committed to charity; it’s just that you get to determine the identity of charities in the future, with no time limit. The recipients must be qualified charities, and it is incumbent on the sponsor of the DAF to verify that fact before a donation (referred to as a grant) goes out. While in the DAF, money can be invested in a way that would align with the likely time frame of money being disbursed. Funds expected to be disbursed in the next 18 months would be allocated to a money-market-like fund while funds remaining in the DAF for many years could be allocated to a growth-oriented portfolio. Larger DAFs ($250,000 and over) can be managed by RCG on a custom basis.

How about other restrictions? There are two to know about. First, you cannot use a DAF to fulfill a legally binding pledge to a charity. The reason for this is you cannot have absolute control over the DAF after funds are contributed; a committee of the DAF sponsor determines whether to issue a grant recommended by the donor, who is referred to as a nominator. I have never seen a DAF turn down a request by a nominator if the recipient is a qualified charity. If a pledge already exists, it may be possible to cancel it and then still fulfill the spirit of the pledge with future grants from the DAF.

The other restriction is that a DAF cannot be used to make a donation where the donor is receiving anything back in exchange. A common situation would be a charity ball or dinner where you donate, say, $250, but your charitable contribution is only $175 because of the value of the meal, etc. With a DAF, you get your charitable contribution when the money or property goes into the account, not when it goes out to the end charity. So there is no way to account for the difference in the contribution later. Incidental benefits like coffee mugs, key chains, calendars, and posters are permitted.

While we are agnostic as to where our clients establish their DAF, we tend to establish most at Charles Schwab because most of our clients’ assets are housed at Schwab. When it comes time to fund the DAF, going from a Schwab brokerage account to a Schwab DAF is a same-day transfer.

The Triple Play – Accomplishing Three Different Objectives with a DAF

The first objective is the most frequently touted benefit, the use of appreciated securities to make charitable contributions. Let’s say you have a security worth $50,000 that you purchased for $20,000. If you were to sell that security, you would have a gain of $30,000 and would pay an income tax anywhere from $4,500 to over $7,100. If you instead donate that security to a charity, you receive a deduction for the full $50,000 (subject to phase-outs of itemized deductions) with no recognition of gain. Then, the $50,000 check that you would have otherwise written to charity can then be used to replenish your investment account for the donated security. Even if you turn around and buy the very same security that you donated, you now have a cost basis of $50,000 for that security instead of a cost basis of $20,000.

This technique has been around for a long time for gifts of appreciated securities directly to the end charity, so how does the DAF differ? That brings us to the second reason to use a DAF. While some of our clients still have mortgages on first or second homes, most do not. Without a large deduction for interest expense on a home mortgage, the remaining itemized deductions that our clients have are real property taxes and charitable contributions. That being the case, you can mostly control when you pay those items, making it possible to “bunch” itemized deductions every other year, i.e., double-up one year and skip the next. In the skipped year, you can use the standard deduction, which is $12,700 for a married couple in 2017. If done perfectly, this technique could save over $5,000 in income tax every other year for a taxpayer in the highest marginal tax bracket.

But before the advent of user-friendly personal DAFs it was virtually impossible to bunch charitable contributions “perfectly” for three practical reasons. The first reason is that you often want to contribute NOW, not next year in your bunching year. The second reason is that a gift of an appreciated security to a charity is only feasible for larger gifts, say $2,500 and up. But what about all those charities to which you donate $50 or $100? With web-based DAF platforms it is possible to issue a grant for as little as $50, solving that issue. You make one donation to the DAF for two years’ worth of your anticipated charitable giving and then issue grants as appropriate over those two years.

The third practical reason is that, before DAFs, our clients would commonly say, “I might change my mind” on the charities I want to support. So, they would not want to double-up on their giving in advance. Again, the DAF solves this problem, because the donor gets to determine the charity receiving a grant at any time in the future. Remember, there is no time limit, though the receiving organization must be a qualified charitable organization.

So far, we have focused on lifetime benefits of DAFs. More and more we see our clients use them as philanthropic legacy tools for after they have died. It is not uncommon for our clients to leave money to one or more charities at death. Some want to leave specific dollar amounts to charity and some specify that any amount more than X total assets going to my family will go to a DAF. Many of our clients want their legacy to continue for many years, so the DAF could be around for generations, with their family in charge of determining grants. A further fine-tuning of such a plan would involve naming the DAF as the beneficiary of a traditional IRA or a qualified retirement plan like a 401(k) plan. Charities, including DAFs, do not pay income tax on such distributions as an individual would, so an estate plan that has both charitable and non-charitable (family) beneficiaries should take this into account.

Donor-Advised Funds versus Private Foundations

Before the advent of the personal DAF, a private foundation was the way to accomplish this type of philanthropic legacy. But private foundations are expensive to set up and maintain and are not private (contrary to the name!), so use of them is now usually limited to where the funding will be greater than $10 million.

Once a DAF has been set up during the lifetime of the donor, it can also be used as a tool to educate younger family members about philanthropy. You could, for example, tell a child or a grandchild that they can give a certain dollar amount to a charity but they are responsible for doing the research and coming up with the reason they selected a particular charity. And you can have family meetings about why you support certain charities so they will be prepared to serve as the “nominator” when you are gone.

In summary, the Donor Advised Fund is an extremely efficient and cost-effective way of accomplishing multiple objectives for your charitable giving. It is rare in the world of tax planning and charitable giving to achieve the baseball equivalent of a triple play, but DAFs, if implemented correctly, will do just that. Resource Consulting Group has the expertise to implement a plan for you; please let us know how we can help.

This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.