An essential component of wealth planning, particularly for high-net-worth investors, is implementing a charitable giving strategy. Leveraging donor-advised funds can help investors meet that objective while gaining significant tax advantages. Financial advisors should partner with a trusted wealth strategist provider to bring these solutions to their clients.
Donor-advised funds, or DAFs, have been increasing in popularity in recent years. In fact, investors contributed more than $73 billion to donor-advised fund accounts in 2021. That was a 47% increase over 2020 contributions.¹ While some of that swing may be attributed to pandemic impacts on the economy, the strategy has been consistently gaining prominence.
What is a Donor-Advised Fund?
A DAF is defined as a philanthropic giving vehicle administered by a charitable sponsor that gives investors a way to make tax-deductible contributions to the fund for an immediate tax deduction.² Investors make an irrevocable contribution of cash, securities, or other assets to the fund and receive an immediate tax deduction for the full market value of the donated assets for the year the donation is made. For investors looking to reduce their taxable income for any given year, this can be a highly valuable strategy.
Once a contribution is made to a DAF, the donor surrenders legal ownership of those assets to the funds. However, they do retain advisory privileges to recommend how the funds should be distributed to qualified charitable organizations, which might include grants to nonprofit organizations, educational institutions, or religious groups, among others.
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DAF Charitable Distributions
Investors contribute to a DAF and dictate their intended charitable benefactor for those funds. The sponsoring organization reviews the recommendations to ensure it complies with legal and eligibility requirements. While the sponsoring organization has the final say on where the money goes, in most cases, they work to honor a donor's preferences. The DAF guidelines will outline how quickly the grants can be distributed, with some having specific payout requirements that must be followed.
When choosing which DAF provider to use, advisors and their clients should carefully consider the investment approach and strategy of the fund. The organization that sponsors the DAF will invest and manage the assets in the fund with the goal of generating growth over time. Investors will see their value fluctuate with market conditions but ultimately, the goal is for the value of the contributions to increase, allowing for more significant charitable impact.
Tax Benefits of DAFS
DAFs offer a number of advantages for investors, most notably tax benefits, that make them highly appealing to the high net worth and mass affluent investor markets. Because contributions are tax-deductible, they are highly useful in helping investors to lower their tax liability. In order to maximize tax efficiency with donor-advised funds, advisors can help clients create a charitable strategy that will enable them to reap the tax benefits while supporting charitable causes they care about.
Contribution Strategies
Contributing assets to a DAF enables investors to avoid capital gains taxes for those assets and receive a deduction for the full market value of the assets. Most have contribution minimums that must be met, which can vary from fund to fund so investors should consider how much they want to contribute.
Donors can make grant recommendations as often as they choose and can elect for their contributions to support different charities over time. If their charitable priorities and needs change over time, they can adjust their contribution accordingly.
Timing is Everything
Advisors should work with clients to leverage the ability to make large up-front contributions to a DAF to claim a higher tax deduction for a particular tax year. This can be especially useful if they are in their highest earning years and are subject to higher income tax rates. Larger deductions can help to lower their tax liability for that year.
Investors are able to maximize their deductions by making larger contributions to a DAF in years with high income and spread out their charitable grants over several years when their income tax liability is lower.
Donating Assets
Contributions to a donor-advised fund can be cash or other assets, such as investments. Investors with highly appreciated, and/or complex assets in their portfolio who are making contributions to a DAF should consider contributing those assets when possible. By donating assets that have appreciated in value, investors can avoid capital gains on those assets while potentially making a larger impact to the charities they have identified.
Qualified Charitable Distributions (QCDs)
Advisors working with clients over the age of 70½ who have an IRA can consider using their qualified charitable distributions as contributions to a DAF. This enables them to satisfy their RMDs and leverage the tax benefits of excluding the distribution from their taxable income.
When it comes to the tax benefits of donor-advised funds, timing is everything. Advisors should carefully consider helping clients to align the timing of their contributions to get the most out of the tax benefits afforded by DAFs.
Donor-Advised Funds and Wealth Planning
Donor-advised funds can be an important part of an overall estate plan to help investors support their charitable giving and potentially reduce their estate tax liability. When it comes to implementing a charitable strategy, clients can take a few basic steps to get started:
- Establish charitable values and which efforts are most important to them
- Include family members in developing and executing a plan
- Designate succession plans to help ensure philanthropic intentions continue through generations
- Meet regularly to assess charitable objectives and other financial factors that might impact contributions
Choosing a Donor-Advised Fund
There is a universe of DAFs to choose from so advisors should help their clients research and plan their charitable giving. Investors should work with their advisor to identify the causes they want to support and ensure the DAF they select aligns with their philanthropic goals. A few factors to consider are:
Costs
Clients should compare both the administrative fees and the costs associated with the underlying investments of the fund. After all, the goal is to benefit charitable causes so it’s important to compare the fees of different providers to make the most of contributions. DAFs can be established to be in existence for a certain period of time or in perpetuity, so costs should be carefully considered.
Contribution Minimums
Different DAFs have varying minimum initial and ongoing donation amounts so clients should consider whether those are amounts that suit their needs.
Underlying Investments
Like any fund within a client’s investment portfolio, DAFs should align with a client’s investment objectives and goals.
Donor-advised funds are a convenient and strategic way for advisors to help clients manage their charitable giving while potentially enjoying tax benefits and flexibility. Because tax laws and regulations can be complex and subject to change, it’s essential for advisors to stay educated about charitable giving and tax planning to create the right strategy to meet the needs of clients.
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