Tax Tips: Reducing Your Tax Burden with Donor Advised Funds

In a previous posting, I discussed how some taxpayers can lower their lifetime taxation by bunching donations into every other tax year, allowing them to itemize one year and then take the standard deduction the following year. There are two significant disadvantages to donation bunching – 1) it requires having excess cash or other investments available to fund a lump-sum contribution, and 2) it may be more difficult for the receiving not-for-profit organization(s) to match the lumpy contribution pattern with their financial needs. While the first disadvantage can’t be fixed, the second one can be through use of a Donor Advised Fund (DAF).

At a high level, DAFs operate just as their name implies—you (the donor) advise the “fund“ managing entity regarding which not-for-profits you want to support. From a donor tax perspective, this is just another form of donation bunching, where you make significant donations to the DAF in one calendar year, and then none in the following year. However, by putting a DAF between you (the donor) and the not-for-profit that will eventually receive the donation, you can now spread the benefit (distributions) to the recipient charity over time.

There are several types of DAFs, but the two I see clients utilizing most often are either a community foundation or self-administered DAF. Here in the Tri-Cities area we have a wonderful not-for-profit organization called Three Rivers Community Foundation (www.3RCF.org). There are several fund options available at 3RCF, and they are even able vet potential recipients on your behalf. This is especially helpful when you have a specific philanthropic area you want to address (education, arts, etc.), but need help finding the local organizations and programs that can benefit most from your donation. I encourage you to visit 3RCFs website and contact them for more information if you are interested.

If a significant portion of your annual donations go to your church (or other faith-based organization) or to not-for-profits located outside of the community, then a community foundation like 3RCF might not be a viable option. If this is the case, then consider creating your own DAF. Three online options that have low fees are Fidelity Charitable, Schwab Charitable, and Vanguard Charitable. The table below shows a comparison between these three options. I personally chose to open a DAF with Fidelity Charitable based on the low minimums for initial deposit of $5,000, no minimums on additional contributions, and the ability to make individual grants as low as $50.

Once you have established an account with one of these organizations, you simply make “contributions” to your DAF as you are able (remember to bunch these by calendar year), and then when you would like the DAF to send money to a not-for-profit of your choice, you make an online “grant” request to the DAF administrator (ex. Fidelity Charitable) and tell them who the recipient not-for-profit is, how much you would like the grant to be, and when you would like it sent. Grant distributions can be one-time, or they can be periodic, such as monthly.

One other nice feature of using a DAF is that your funds can remain invested prior to final distribution, and any earnings on the fund will be available for future grant requests. For all DAFs, it is important to understand 1) that your donation for tax purposes is based on when you contribute the money to the DAF (you do not get tax credit for the grants that go out of the DAF at a later date), and 2) that your donation to the DAF is irrevocable…you can’t take it back once it is placed in the DAF. You should also make sure that you clearly understand the fees associated with the DAF option that you choose.

Paul Hansen, CPA, CFP®