Donor Advised Funds: Nice Tax Breaks But Actual Giving Lags
$120 billion — and rising — in accounts now open to smaller savers
An increasingly popular way to donate money may be slowing down how fast the money actually gets into the hands of charities.
Donor-advised funds (DAF) may sound like they are something for the 1%, but they are in fact an increasingly popular way for more regular folk to do their charitable giving. Fidelity, Schwab and Vanguard all offer DAF programs. Fidelity Charitable, the biggest DAF sponsor, recently got rid of any required minimum initial contribution to open a DAF. Schwab requires $5,000 to open an account, and Vanguard requires ponying up $25,000 to open a DAF.
From 2014 through 2018 (the most recent data available) money in DAFs grew at an annual rate of nearly 15%. At year-end 2018 there was more than $120 billion sitting in DAFs according to the National Philanthropic Trust.
A DAF is a personal account. The entire amount contributed to a DAF in a given year is eligible to be claimed as an itemized federal tax deduction. But there is no required timeline for how fast money in a DAF must be granted (donated) to charity. In fact, you can leave the money growing for years, or slowly drip the money out to charities. The $120+ billion sitting in DAFs is money that has been promised to charities, but has not yet been deployed.
Granted, that’s exactly how private foundations work: There’s a big pot of money and only a small portion is typically distributed to charities in any given year. But foundations have to hit a minimum annual grant level of 5%. DAFs are under no such regulations.
A DAF can indeed be a smart and effective way for households to handle their charitable giving, but before you jump on the DAF bandwagon, it’s worth weighing the pros and cons.
The fact that you can grab a big tax deduction when you move money into a DAF without having to actually send money to a charity is marketed by DAF sponsors as a nice bit of flexibility: Take the full tax break today, then take your time deciding when and how much you want to actually send to charity. And in the meantime you can keep the money in safe cash-like accounts, or invest it, with an eye on boosting your eventual gifting.
Fidelity has estimated that on average about 20% of the total assets in DAFs is sent to charities in a given year. A recent academic working paper took issue with how the industry calculates the giving rate, and suggested a more accurate approach that reduced the 2017 average payout rate to less than 15%.
A crude interpretation of that would be that on average it takes nearly seven years for money earmarked for charities in a DAF to actually make it into the operating budget of charities.
That’s totally within the rules. And if you come into a windfall inheritance, business sale or IPO bonanza and want to carefully consider how best to deploy it, parking money in a DAF gives you that time. But if inertia sets in and you let the money sit there for years for no good reason, there are charities missing out.
That might come into play if you’ve been advised to take advantage of the charitable donation “bunching” strategy that can reduce your federal tax bill.
Higher income households living in states with income tax and elevated housing prices have borne the brunt of a federal tax reform change that since the 2018 tax year limits the deduction for state and local taxes (SALT) to a maximum of $10,000 per household. That’s $10,000 whether you’re married or single. At the same time, the standard deduction was raised. This year it’s $24,400 for married couples and $12,200 for individual filers. With a $10,000 SALT limit, most married couples are better off sticking with the standard deduction.
But if they are charitably inclined, the DAF creates an interesting way to boost their itemized deductions in a given year, which will reduce their tax bill. For instance, let’s say a couple typically donates $10,000 a year to charity. Combined with the maximum $10,000 SALT deduction, they are still better off with the standard deduction. But with a DAF they could bunch multiple years of giving into one year. If they have the cash flow, they might fund $30,000 in their DAF this year, take a $30,000 deduction, and then if they want, make $10,000 in grants to charities over each of the next three years. (To be clear, there’s nothing preventing them from granting the entire $30,000 as fast and soon as they are ready.)
A DAF can also be a smart way to deal with stocks and other appreciated assets that would trigger a big capital gains bill when sold. You can direct your DAF sponsor to sell the asset and place the proceeds in your DAF account. Because the proceeds have been promised to charity, there will be no capital gains tax on the sale, and you can then also claim the amount as a charitable deduction. That can be especially helpful if you want to give to a charity that can’t process appreciated stock or other assets; many small ones don’t have the expertise to handle that. You can have the DAF sponsor sell an asset and place the proceeds in your account, and then you authorize the money to be disbursed to the charity.
But all this comes at a cost. The DAF sponsors collect an annual administrative fee and there are annual investment costs as well. Which would seem to be a disincentive for the DAF sponsors to encourage aggressive granting (spend down) of DAF accounts.
At Fidelity, Schwab and Vanguard the standard annual fee is 0.60% for accounts with less than $500,000. And you will then have a choice of various ways to invest the money, that can run from 0.03% or so (cheap index funds or cash-like savings accounts) to more than 0.85% a year for an actively managed portfolio. Granted, technically you’re not paying that fee. The charities you eventually send money to are. On a $25,000 account with a combined annual fee of 1%, that's $250 a year that isn’t going to charity.