The percentage of rich people in America has risen substantially over the past several years, and many of these individuals are turning to donor-advised funds (DAFs) to assist with their charitable efforts. At the end of 2015, a record 10.4 millionaires—individuals with a net worth of $1 million or greater, excluding the value of their primary residence—lived in the U.S. According to a 2014 study by U.S. Trust and Indiana University, these high-net worth people list philanthropy as their third most important priority. This has led to an explosion in the use of DAFs, which are funds set up for charitable purposes that can facilitate large donations. But these funds have received a fair amount of criticism regarding how they work and the benefits that they provide to society.

Let's examine the nature and use of DAFs as well as their benefits and drawbacks. (For related reading, see: Characteristics of the Ultra Wealthy.)

How DAFs Work

Donor-advised funds are registered 501(c)3 organizations that are funded with cash, securities that have appreciated in value and/or other assets. All of the contributions are put into an account in the donor's name, which is held by a DAF sponsor and eventually donated to a charity of the donor’s choosing. Donors are able to take a current tax deduction for contributions made to the fund; this is an important feature because it allows a donor to take a tax deduction for all contributions at the time they are made, even though the money may not be dispersed to a charity until much later. This incentivizes donors who need a tax deduction to make a donation now and then decide where the money will go at a later time when it’s convenient.

Unlike some charities, DAFs are very well-equipped to convert appreciated securities or other tangible assets into cash The ability to do this can enable many folks to give a larger amount than they would otherwise; for example, a donor with 1,000 shares of Inc. with a very low cost basis can hand this over to a DAF and take an immediate deduction for the full value of the donation (subject to IRS limits). If he wanted to do the same for a local homeless shelter, he would have to sell the stock and pay the capital gains tax on the sale. (For related reading, see: Tips on How to Discuss Philanthropy With Financial Advisory Clients.)

Unexpected Beneficiaries

Despite their relative efficiency, DAFs have come under fire for the fact that they are not legally required to spend the money that they receive and can hold it for as long as they want. 

Furthermore, the fine print in the agreements explicitly states that donors cede all legal control of their contributions to the DAF sponsor. Although the sponsors promise that donors will retain control, the fund has the final say in what happens to the money. One DAF sponsor that went bankrupt had all of its donations seized as collateral, leaving the donors without funds to give to the charity of their choice. Another used contributions to provide its employees with a very generous compensation plan, host a golf tournament and pay the legal fees for a lawsuit from an irate donor. In both instances, the courts upheld the sponsors’ right to use the donated funds as they saw fit.

Another complaint that has been levied at DAFs is that the funds profit from the donations they receive via the fees that they charge to donor accounts. For example, Fidelity charges the greater of $100 or 0.06% for the first $500,000 of donations to its fund. It can also make additional money off of the charges that are assessed by the mutual funds that donors invest in. DAFs often carry many hidden fees that donors are unaware of in the same manner as 401(k) plans.  Notably, while the amount of contributions to DAFs is mushrooming, the amount of disbursements has only grown by about half as much. Critics therefore contend that the financial industry and its wealthy clients, rather than charities, are the true beneficiaries of DAFs. (For related reading, see: Top Tips for Maximizing Charitable Deductions.)

Strong Interest in Philanthropy 

Nevertheless, DAFs have nearly doubled the amount of money that they have paid out since 2010. The National Philanthropic Trust has paid out over $625 million in the past year alone, while Fidelity Charitable and Schwab Charitable have reported 14% and 12% year-over-year increase, respectively, in distributed grants within the first half of 2016.

The aforementioned U.S. Trust and Indiana University study indicates that over 98% of high net worth households give to charity in some capacity. However, only a fraction of advisors talk with their clients about charitable planning, and this represents a missed opportunity on a vitally important topic. Krystal Kiley, a vice president of relationship and practice management at Fidelity, said that advisors who ignore this subject run the risk of doing a serious disservice to their clients. “There’s $30 trillion of assets in motion right now that’s expected to transfer from the Boomer generation to their heirs,” Kiley says. “What many people don’t realize is that close to a third of that wealth is expected to end up in charitable giving. As a result, this is an important area where advisers can differentiate themselves and stand out from the competition.”

The Bottom Line

Donor-advised funds can provide donors with an immediate tax deduction for funds that may not actually be distributed to a charity until months or years later. While this time lag has been the source of criticism for these funds, their use has exploded in recent years among high-net worth households in America. Financial advisors need to understand how these funds work and know when they are appropriate to use with their clients in order to serve them effectively. (For more, see: The Most Overlooked Tax Deductions.)