The Advantages of Using a Donor-Advised Fund

I’ve talked about giving several times on ESI Money. It’s been an important part of our lives, and since this site is about what we did to become financially independent and retire early, it makes sense that giving is covered like the other issues.

To be more specific, even while we were saving for financial independence, we were also donating 26% of our gross income to various charities.

The reason we gave while we saved for FI was stated in Where Does Giving Fit with Financial Independence? as follows:

Our feelings are that people are hungry now, people are suffering now, people need help now — so how could we wait to give?

Besides, if you can grow your income enough and keep expenses low, you can do it all — pay down debt, save, and give. That’s what we did.

That said, we didn’t always do it the right way.

How Our Giving Could Have Been Better

In the Top 10 Money Mistakes I Made on the Way to FIRE I listed one mistake as giving the wrong way. Here’s what I said there:

Back in the day donor-advised funds weren’t as popular or as sophisticated as they are today.

As a result, we gave most of our funds through income.

Instead we should have given appreciated assets out of our investments. Then we could have used our income to buy more investments, effectively raising the cost basis in our investments and reducing our future tax burden.

I’m not sure how much this is going to cost us in extra taxes, but probably a few hundred thousand dollars at least.

Lesson to be learned from my mistake: Give the right way. Use all the advantages (like a donor-advised fund) that the government allows to minimize the tax implications of giving and investing.

Oops.

This wasn’t my only mention of a donor-advised fund (DAF). I’ve brought it up now and then in passing — in retirement updates, in the comments, and so forth.

Each time I do, I get a few responses asking for details of why and how to use a DAF.

This post, which gives details on donor-advised funds and suggests ways anyone can use them to increase the impact of their giving and benefit their finances, is in response to those requests. 😉

And FYI, I’ve seen it spelled both “donor-advised fund” and “donor advised fund.” I’m using the former because it appears most of the sites/organizations I trust spell it that way, but there are other credible organizations that use the latter. Just so you know, the sources using various spellings are talking about the exact same thing.

Before we get to specifics of why and how to use a DAF, let’s start at the beginning…

What is a Donor-Advised Fund?

Here’s a quick summary definition of DAFs from the National Philanthropic Trust:

A donor-advised fund, or DAF, is a giving vehicle established at a public charity. It allows donors to make a charitable contribution, receive an immediate tax deduction and then recommend grants from the fund over time. Donors can contribute to the fund as frequently as they like, and then recommend grants to their favorite charities whenever makes sense for them.

To add more detail, Vanguard Charitable (the DAF we use), tells us how one works:

A donor-advised fund is a tax-effective way to consolidate, accrue, and grant assets to 501(c)(3) public charities. To establish a donor-advised fund, or philanthropic account, at Vanguard Charitable:

• Make an initial contribution to establish your philanthropic account. Because Vanguard Charitable is a 501(c)(3) organization, contributions to Vanguard Charitable are tax-deductible.
• Recommend investment options for the donated assets. Assets in the philanthropic account grow tax-free.
• Recommend grants to eligible public charities you wish to support.
• Establish your charitable legacy with a succession plan which reflects your values.

Those two explanations are good, but they are a bit “stuffy” IMO for someone completely new to the topic.

Here’s my layman’s version of what a DAF is and how it’s used:

• A DAF is an account you set up with an organization established to hold donated assets for later charitable disbursement. Think of it as a charitable trust of sorts for those of us who aren’t named Gates or Rockefeller. As I said, we use Vanguard Charitable.
• Once the account is set up, the individual/family can make contributions to it, either in cash, securities, or a whole host of assets. Once the donation is made, it is irrevocable — just as if you gave it directly to a charity like the Red Cross, American Cancer Society, or Salvation Army.
• Since the donation is officially made when the money/assets are given to the DAF, donations are immediately available to claim as tax deductions (for the filing year in which they are transferred.)
• From there the donations are invested in accordance with the contributor’s wishes and can sit and accumulate just like any investment.
• When the donor wants to distribute the funds, he technically makes a recommendation to the DAF account holder, asking that funds of $XXXX be sent to ABC charity. He doesn’t direct the funds with certainty because he doesn’t own them any longer. That said, generally the funds are disbursed in accordance with the donor’s wishes.
• The account lives on with the cycle of donations and disbursements until the donor is done with it or dies, at which point the funds are distributed either according to the DAF’s guidelines or the donor’s wishes.

This all still might seem a bit vague to some, so let’s see if I can clear it up by using an example.

How We Use Our Donor-Advised Fund

I’ll give some details of the way we use our DAF, but won’t give any explanations as to why, what the advantages are, etc. — we’ll get to those later.

Here’s how we use our DAF:

• We already have an account at Vanguard Charitable. If you don’t have one at a DAF organization, they are pretty easy to set up — very similar to opening an account with a mutual fund company.
• I go into our Vanguard Charitable account and say I want to make a contribution. When it asks me where the funds are coming from, I select our Vanguard taxable brokerage account. It connects me to the account and I direct it to move shares/dollars to the DAF.
• Let’s say I tell it to move 100 shares of Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) at a price of $70 a share. So $7,000 gets moved to the DAF. I now no longer own that money and I can count it as a $7,000 charitable deduction on my taxes.
• I choose how the $7,000 is invested in the DAF. There’s a wide range of options. I can be as conservative as I want with more of an asset preservation option all the way up to an aggressive growth investment.
• When I decide I want to make a charitable contribution, I go into the DAF account online and recommend a disbursement. For instance, I might suggest that $2,500 be sent to the Salvation Army and $2,500 sent to the American Cancer Society.
• Vanguard Charitable reviews my suggestion and assuming they are in agreement with it, they send the money to each charity.
• I’m now free to add more or distribute the rest at my discretion.

To note, there are fees for this service and there are minimums you need to maintain. We’ll get into those later.

For now, that example should give a good idea of how things work.

What are the Advantages of a DAF?

You may have already identified a few of the benefits of using a DAF, but let’s state them outright to be sure I’m completely clear.

We’ll begin with some thoughts from the American Endowment Foundation:

Donor-advised funds provide five primary tax benefits to the donor:

• Income Tax: You receive an immediate income tax deduction in the year you contribute to your DAF. Since AEF is a public charity, contributions immediately qualify for maximum income tax benefits. The IRS does mandate some limitations, depending upon your adjusted gross income (AGI). (Deduction for cash – up to 60 % of AGI; Deduction for securities and other appreciated assets – up to 30 % of AGI; There is a five-year carry-forward for unused deductions.)
• Capital Gains Tax: You will incur no capital gains tax on gifts of appreciated assets (i.e. securities, real estate, other illiquid assets.)
• Estate Tax: Your DAF will not be subject to estate taxes.
• Tax-Free Growth: Your investments in a DAF can appreciate tax-free.
• Alternative Minimum Tax (AMT): If you are subject to alternative minimum tax (AMT), your contribution will reduce your AMT impact.

And here’s Vanguard’s take on the same issue. It’s a combination of the advantages of a DAF and the advantages of working with Vanguard Charitable:

• Tax-free growth: Contributions to a donor-advised fund get invested and grow tax-free. This means the return on your charitable contributions can go straight to the charities you admire.
• Unlock new tax-friendly assets: Did you know that savvy donors mix cash donations with in-kind contributions of appreciated securities, private equity, and even real estate? Donating appreciated assets is free of capital gains taxes, and contributions of illiquid assets can solve many estate planning issues for you and your family while simultaneously expanding your philanthropic playing field.
• Think long term: A Vanguard Charitable DAF amplifies your giving potential and gives you long-term flexibility, maximizing tax advantages in the years you need them. Whether you are planning a large gift, managing a windfall or high-income year, or looking to continue your giving after retirement, we can help.
• Leave the legwork to us: Prefer to leave the onerous record-keeping to someone else? Grantmaking is hard work, but not with Vanguard Charitable. We conduct due diligence for you so you can rest easy, and we keep comprehensive giving records in one, easy-to-access location so you’re ready for tax season.
• Our low all-in fee: Tax-free growth maximizes your charitable impact. So do our super-low fees. Vanguard Charitable’s all-in fee is simple and among the lowest in the industry. (And it just got lower.)

As you can see, there are several advantages to a DAF.

The benefits I think are most valuable are as follows:

• You get a tax deduction in the year you contribute to your DAF. You don’t need to wait until the dollars are disbursed.
• You can give appreciated securities/assets while avoiding capital gains taxes. This allows you to both maximize your gift and minimize the government’s cut.
• You can combine contributions in years to get the full income tax benefit. I’ll tell you how in a bit.
• You can distribute the funds over the course of many years, a great benefit for those who retire early (as we’ll see).
• It’s a pretty easy way to give — especially if you have your assets at Vanguard and use Vanguard Charitable. I assume it’s the same if you use Fidelity and others that have the same arrangement.

Vanguard notes above that one advantage is investing your donations and have them grow for years before distributing them.

That’s good if you’re willing to take the same risks with your giving as you do with your investing (the investments can go down, of course.) It really depends on your time horizon for distributing, just like in investing.

I don’t invest my donations in anything aggressive as I plan to distribute them within a year or two, so this isn’t a big advantage to me.

The Downsides to DAFs

A search for “downsides of donor-advised funds” doesn’t turn up much that’s very meaningful, because if you want to give, they are pretty awesome.

But there is one issue worth noting as follows:

Of course, DAFs have drawbacks, primarily related to donor control.

Once a donor contributes to a DAF, the organization managing the fund has legal control over it—in other words, the gift is irrevocable. The donor may indicate an investment objective or strategy offered by the managing charity but does not control the investment.

Additionally, while a donor can recommend charities to receive grants, the donor does not reserve the right to direct distributions. Ultimately, the managing charity has the authority to approve or deny any recommendations made by the donor.

In other words, once you make the donation, you lose control. You can not get the money back — it’s gone.

In addition, you can only recommend how the funds are disbursed — you can’t mandate it. That said, you can mitigate this last risk. You do this by looking at a list of approved charities for your DAF account before you establish one to make sure your favorites are approved. That’s what I did.

The Advantage in Avoiding Capital Gains Taxes

Since some of the advantages I detail above are best illustrated with an example, let’s do it!

We’ll look at them one at a time beginning with this one:

You can give appreciated securities while avoiding capital gains taxes. This allows you to both maximize your gift and minimize what the government’s cut.

Let’s say you have the following circumstance:

• You own 1,000 shares of index fund ABC at $50 per share or $50,000 total at today’s market value.
• You bought the shares 5 years ago when they were $30 a share (total $30,000), so you’re sitting on a $20 per share capital gain ($20,000 total).
• You want to donate these shares to a charity.

There are a couple ways you could give…

Option 1: Sell the shares and give cash to the charity.

If you sell the shares first, you owe capital gains tax on the $20k.

The current capital gains tax rates vary based on your tax filing status and income.

Let’s assume you’re in the 15% capital gains tax bracket. That means you’ll owe $3,000 tax ($20,000 * 0.15) on the sale.

As a result, you’ll have $47,000 left after the sale ($50,000 less the $3,000 in taxes).

You can now give $47k to the charity.

Option 2: Move the shares directly to a DAF and then distribute.

In this case, you’d transfer the $50k in shares to your DAF. If you have a Vanguard to Vanguard Charitable arrangement (or something similar) this takes about two minutes to do online.

In this case the entire $50k is the donation and no tax is due.

You can now distribute the $50k to your charity.

Of course you could always donate the shares directly to the charity and also avoid the tax, but that can be a hassle. Believe me, I know from experience.

Back in the day when DAFs didn’t have as many options and weren’t as easy to use, I wanted to donate appreciated index fund shares to an organization. I talked to a DAF and they told me they weren’t sure whether or not my recommendation to give to this organization would be approved or not simply because they hadn’t worked with them before (the donation choices were limited). Note that I wanted to give to an established 501(c)(3) so it wasn’t like I was donating to my “brother” in a foreign country or something shady like that.

Since they couldn’t guarantee that my recommendation would be followed and I wasn’t about to give if it was possible my money wouldn’t go to my selected charity, I decided I would give shares directly to the organization to avoid capital gains tax. The ensuing complications were not pleasant.

First, Vanguard had me fill out enough paperwork to choke an elephant.

Second, the charity had to spend countless hours figuring out how they could receive the shares (this involved a lot of back and forth with me, which was frustrating).

It finally happened (I actually did this a few times) but it was painful. Using a DAF makes it easy as they have established ways of accepting assets and then sending cash to charities, making the process very smooth.

Using a DAF is Good for Cash Contributions as Well

Even if you can give cash, I’d encourage you to donate through a DAF. Here’s why…

Let’s use the same numbers in the example above:

• You own 1,000 shares of index fund ABC at $50 per share or $50,000 total.
• You bought the shares 5 years ago when they were $30 a share (total $30,000), so you’re sitting on a $20 per share capital gain ($20,000 total).
• You want to donate to a charity.

Instead of giving the $50k in cash, here’s what I would do:

• Make the $50k donation to your DAF using appreciated shares as noted in option 2 above.
• Take the $50k in cash and buy the same shares at the current market value.

Doing this you have both 1) given the maximum to the charity (by avoiding the capital gains tax) and 2) reset your cost basis at $50 a share versus $30 a share (putting you in a better position to avoid or lower capital gains taxes if you want to sell outright in the future).

This is where I messed up while I was saving, though it wasn’t all my fault.

Today I am sitting on massive capital gains in my brokerage account, so if I was to sell now, I’d owe a ton.

If I had given appreciated assets instead of cash for 28 years, my cost basis would be much higher and I’d have much lower potential capital gains tax liabilities.

Of course, as I said, DAFs were not as advanced then so I’m not sure I could have done what I wanted. But you certainly can these days.

In addition, it’s likely I’ll be giving away the entire amount of my taxable account (right around $400k now) over the next decade, so I’ll probably avoid the taxes anyway. But if you want the option to sell and keep as much as possible, using a DAF to increase your cost basis is a great strategy.

One note/reminder/limitation from above: “Deduction for securities and other appreciated assets – up to 30 % of AGI”. You are limited in what you can deduct for any given year, so keep this in mind as you donate.

The Advantage of Combining Contributions to Lower Income Taxes

Here’s the second example based on this advantage:

You can combine contributions in years to get the full income tax benefit.

Currently the 2019 federal income tax standard deduction for a couple who is married and filing jointly is $24,400 So unless you have itemized deductions above that amount, anything you do (like donate securities) will bring you no tax advantages.

But with a DAF, you can bundle your deductions to get a benefit.

For example, let’s say you have the same $50k in securities and want to give $10k per year for the next five years.

If you actually do give $10k per year, there’s no tax advantage as you won’t get above the standard deduction.

But with a DAF, you can donate the entire $50k in one year and get the tax deduction for that year — well above the standard deduction (of course, you’re still limited by what you can deduct based on AGI, so take that into account).

So in year one, you’d itemize since you’re above $24,400 and in the other years you’d take the standard deduction (assuming all cumulative deductions are below $24.4k) to minimize income taxes.

Then you’d distribute your funds over the next five years, $10k per year, using your DAF.

As you see, these examples work mostly for high income individuals. But this site does have a lot of millionaire readers who earn a ton and I wholeheartedly recommend earning more versus earning less! 😉

The Advantage in Preparing for Giving in Retirement

Finally, here’s the third example for the following advantage:

You can distribute the funds over the course of many years, a great benefit for those who retire early.

I know several early retirees who are 1) cash/income strapped (or at least prefer the flexibility of having more cash), 2) asset rich (especially appreciated assets), and 3) want to give even in retirement.

This is where bulking up your DAF can be a great benefit.

For example, if you know you’ll be retiring in five years, you can build up your DAF (with assets and/or cash) in those years, then distribute the proceeds for years to come in retirement.

In effect you are pre-paying your donations/giving. This way, you can keep giving well into retirement with zero impact to your retirement income/cashflow or assets.

Our Experience and Plans with DAFs

A bit of background on what we’ve done with our DAF so far and some future plans:

• We opened our DAF in November 2016 shortly after I retired.
• Since then we have contributed roughly $226k of appreciated index fund shares from Vanguard to Vanguard Charitable. It helps that the market has been on fire during this time. 😉
• We have distributed all but $96k at this point. We are looking to make a big disbursement at the end of this year as you’ll find out in a few days. 😉
• The distributions we do make are based on our goals (of course). These days even churches are approved to receive these funds and we do our church giving this way.
• As the funds run low, we make another contribution and the cycle repeats itself.
• Eventually we may give real estate or other assets (our house?) in this way, but I’d have to do a lot of due diligence before I proceeded. Perhaps in later years we’ll contribute the required minimum distributions (RMDs) from our IRAs.

One last note before I wrap up: there are fees for both DAF administration and investments, so check these out in advance for any DAF you’re considering.

Here are the fees (as well as account minimums) for Vanguard Charitable if you’re interested.

A DAF is a great tool and if you use it wisely you can maximize your giving while decreasing taxes, all while making the giving of appreciated assets very easy.

Anyone out there use a DAF? How do you use it and how do you like it?

P.S. For those who prefer a video version of this post, see the ESI Money YouTube channel.