Donor Advised Funds: What are they and how do they work?

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If you are investor and want to give to a charity you might consider a donor advised fund.

Donor advised funds are a popular and easy way for many investors to give to charity – though not everyone understands how the funds work.

This can lead to costly mistakes.

In this article, we look at how donor advised funds work and how you can avoid any pitfalls.

What Is A Donor Advised Fund?

The concept behind donor advised funds is simple.

You – the donor – make a tax-deductible contribution to the fund. That deduction is given the year you donate to the fund and not when the charity gets the money. This way the money can be invested and grow tax free.

You can give from the fund to your charity of choosing years later and the best part is if you donate appreciated equities then nobody pays capital gains taxes. This allows the donor to make a much larger impact. This leverages your ability to make more charitable gifts over time.

A nice ancillary benefit to a donor advised fund is that contributions to the funds themselves are deductible at up to 50% of adjusted gross income, Contrast this with a 30% limit on contributions to some private foundations.

Even better, the fund's managers take on the paperwork duties, and thus some of the headaches – nice!

Of course, this isn’t all roses and rainbows – the funds do charge fees. In addition, there are no guarantees that the investments in their portfolios will perform well.

More concerning and confounding to some financial advisers are the kinds of misunderstandings some clients continually show when it comes to donor advised funds.

Here are common pitfalls and misconceptions.

No Second Deductions With Donor Advised Funds

It’s a common misconception that there is a second tax deduction when your charity receives a distribution from the fund.

Unfortunately, there is no second tax deduction. Instead your tax deduction stems from your initial donation to the donor advised fund.

You also must keep in mind that what you contribute to a fund and what is paid out to a charity can differ. This is due to market fluctuations and can cause confusion and consternation if you aren’t aware of it.

Also, once you donate the money to the fund you can never get it back. It is considered donated and gone from your possession even though you still control it.

Your Charity May Not Be Approved For A Donor Advised Fund

Do not always assume that your fund will allow you to donate to any charity you choose.

The reality is that donor advised funds must approve a charity before any transfer of money is made.

This means that while larger charities such as universities are likely already approved smaller charities might not be approved by the fund.

It is imperative that you make sure that the charities you wish to donate to are approved by the donor advised fund before making a donation to the fund.

If the smaller charities aren't approved, you can ask the fund's managers to get them on the approved list.

There Are No Goods or Services For Donating To A Fund

One of the biggest mistakes that financial planners see is when clients want something in exchange for their charitable contributions.

Donor advised funds insist that any donation is made with the understanding that no goods or services were received for the gift.

If you want to use the money that you donate to the fund to buy a vacation rental through a charitable auction that is a big no-no.

Unused Funds Go to Waste If They Don’t Support Charities

Don’t fall into the trap of creating a donor advised funds without having any true charitable intent. The assets just sit in the fund without supporting any charity.

Some people create donor advised funds in order to partially offset a taxable windfall.

In this case, funds will languish each year because there was never a strategic charitable-gifting approach.

Make sure you develop strategic giving plans or instead invest the money profitably until you develop a gift giving strategy.

Where should I open a Donor Advised Fund?

Both Vanguard and Fidelity have good charitable giving funds. Both have a variety of investment options with low fees, but Fidelity allows grants to be made as low as $50. There is an additional expense ratio of 0.6% and there is comparable to tax drag seen on a taxable account (e.g. 2% dividends taxed at 30% = 0.6%)

Watch Your Budget

Finally, while donor advised funds can help you take bigger charitable deductions in some years than you might have otherwise, be careful not to overestimate how generous you can afford to be.

The last thing you want or need is for a problem to arise if you experience a cash pinch. You need to keep in mind that all money placed in donor advised funds is irrevocable.

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