Donor-Advised Funds: The Benefits and Drawbacks

The percentage of rich people in America has risen substantially over the past several years. According to the Credit Suisse Research Institute Global Wealth Report 2021, which was released in June, by the end of 2020, nearly 22 million individuals with a net worth of $1 million or greater lived in the United States. According to Wealth-X’s Very High Net Worth Handbook 2021, philanthropy is the top interest, passion, or hobby of very-high-net-worth individuals in North America, cited by 31.2% of them.

Many are turning to donor-advised funds (DAFs) to assist with their charitable efforts. Indeed, according to the 2021 DAF Report by the National Philanthropic Trust, U.S. investors contributed $34.67 billion to charitable causes using DAFs in 2020, an increase of 27% over 2019.

What Is a Donor-Advised Fund (DAF)?

DAFs are funds set up for charitable purposes that can facilitate large donations. They are run by a third party and created to manage the donations of an individual, a family, or an organization.

Though DAFS have proven quite popular, they also 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.

How Does a Donor-Advised Fund (DAF) Work?

DAFs are registered 501(c)(3) organizations that are funded with cash, securities that have appreciated in value, and other assets. All of the contributions are put into an account in the donor’s name, which is held by the 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.

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 Amazon.com 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 Internal Revenue Service (IRS) limits.

If the donor wanted to do the same for a local homeless shelter, they would have to sell the stock, pay the capital gains tax on the sale, and then donate the cash.

Disadvantages of Donor-Advised Funds (DAFs)

Despite their relative efficiency, DAFs have come under fire because they are not legally required to spend the money 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.

There are disadvantages to using donor-advised funds. For example, the National Heritage Foundation went bankrupt in 2009 and had all of its donations seized as collateral, leaving the donors without funds to give to the charity of their choice. According to reporting by The New York Times, 9,000 funds totaling $25 million in value were wiped out.

According to reporting by PBS News Hour, another company 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 of the above 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 Charitable charges the greater of $100 or 0.6% 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 in which donors invest. DAFs often carry many hidden fees of which donors are unaware, similar to 401(k) plans. Critics, therefore, contend that the financial industry and its wealthy clients, rather than charities, are the real beneficiaries of DAFs.

Benefits of Donor-Advised Funds (DAFs) 

The main benefit of a DAF is the ability to make a donation and take an immediate tax deduction for it while waiting to decide how the donation should actually be used. While the donation is irrevocable, it can grow tax-free in the DAF via investment while the decision is being contemplated.

Of course, a DAF should not be used to park money for long periods of time. Despite the critics who claim that happens too often, the National Philanthropic Trust’s 2021 Report says that DAFs have more than quadrupled the amount of money that they have paid out since 2011, which, as noted above, was $34.67 billion in 2020.

There are also benefits to financial advisors. A 2020 study by Fidelity Charitable found that financial advisors who include charitable planning in their work can see significant advantages in their business. They had six times the median assets of advisors who don’t include it, three times the organic growth, and 1.3 times the median new money per investor.

The same study found that 76% of clients used a DAF to donate appreciated assets, 68% used it to give them time to decide where to give, and 62% used it to sustain their giving through retirement.

The Bottom Line

DAFs 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 a source of criticism, the use of DAFs 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.