This week, Gail explains how a donor-advised fund works.

Dear Gail-

We’re not what I’d consider “wealthy,” but my wife recently inherited a small amount of money — about $18,000 — and before it gets spent on a lot of little things we’ll never remember, we’d like to donate a chunk of it to charity. We’d also like to use this to teach our children — Brinn and Ellie, ages 7 and 9 — about philanthropy and the importance of remembering those who aren’t as fortunate.

My wife and I routinely give to our church, but other than that, we disagree on which charities should receive this money. My preference would be to give the whole amount to one charity so it really makes a difference. My wife would like to spread it around.

I’ve heard about “donor-advised funds,” but don’t know a lot about them. Can you tell me how they work? Would we still get a tax deduction if we went that route?
Thanks,
Carl

Dear Carl-

What a thoughtful idea! And your timing couldn’t be better: November 15th is “National Philanthropy Day.”

Think of a donor-advised fund, or “DAF,” as a charitable gift with the potential to keep on giving. It’s a great way to support causes you believe in and at the same time teach succeeding generations important lessons about sharing their blessings. In fact, a DAF can allow you to create a legacy that will continue to support the organizations that your family cares about even after you and your wife have died.

The first thing to understand is that a donor-advised fund is itself a legally-established charity. This means that when you make a contribution, you get a tax deduction for that year even if no distribution is made. (More about how much you can deduct later.) As is the case with any tax-deductible charitable donation, your contribution is irrevocable; you cannot ask for it back.

Like a 401(k), a donor-advised fund offers a number of investment options, or pools of money. Since many DAFs are sponsored by mutual companies, they simply use mutual funds for this purpose. You “advise” the DAF as to how your contribution should be invested. Typical choices include pre-determined “asset allocation” pools which are professionally managed based on a particular investment goal such as “moderate growth,” or “preservation of principal.” Some DAFs also allow you to customize your investment pool by combining individual mutual funds.

Once your DAF account is established, you can then “advise” the trustees of the donor-advised fund as to which charities you would like to receive “grants” (distributions) from your account and in what amounts. To qualify, the organization must meet the IRS definition of a charity (1) or private operating foundation (2). This includes all of the groups you would typically think of: religious entities, non-profit hospitals, environmental groups, museums, educational establishments, organizations dedicated to scientific/medical causes, and so forth. In fact, any charity that is registered in the United States qualifies. It’s possible to support charitable causes outside this country simply by recommending that your DAF account make a grant to an international charity with a presence here. UNICEF and the International Red Cross are two examples.

The trustees of a donor-advised fund review all grant recommendations to ensure the money is going to a qualified charity. If they determine that this is not the case, they can deny your request. That’s because there are serious penalties for the DAF if its assets aren’t used to support other bona fide charities.

Your recommended “grants” to the charities of your choice can be made in your name or anonymously. Note that since you received a tax deduction when you made your contribution to the donor-advised fund, you do not get another deduction when money from your account is distributed.

Since a donor-advised fund is a charity (think of it as a charity that’s holding on to your contributions until you instruct it to distribute the money to another charity), you are not taxed on the earnings your account accumulates. This means you could potentially be able to give more to the charities of your choice as your initial contribution grows in value. (Of course, your account can also decline in value if the investments you choose go down.)

You should receive regular reports — generally quarterly and annually — on the balance in your DAF account. This will detail not only how your investments are performing, but will also list all grants that have been paid out and any additional contributions that have been made.

When you set up an account in a donor-advised fund, you can name it virtually anything you wish. For example, I might call mine “The Buckner Family Charitable Giving Account.” Third parties are allowed to contribute to a DAF, so if other family members support what you’re doing, they can make donations to your DAF account. They would get the tax deduction.

As the individual making the initial contribution, you would be the “primary” donor. However, you can appoint others who would also have the power to make recommendations about how the account is invested and who could authorize grants to specific charities. You would also name “successor donors” to take over when you and the other advisors you named have died. Your successors can continue the job of recommending how the remaining money should be invested and disbursed.

Since they are minors, your children are currently too young to serve as advisors. But they are certainly old enough for you to engage them in a discussion about what kinds of people and/or causes they would like to help and why it’s important to help those less fortunate. Unlike gifts made to a “community fund,” which are strictly local, DAF grants can range from local to global in scope. For instance, if your daughter is an animal lover, perhaps she would like a contribution made to the humane society in your town. Your son might want to help save the Amazon rain forest or assist victims of a natural disaster.

Donor-advised funds must distribute at least 5 percent of their assets each year. However, this is based on the total amount of money disbursed by the DAF itself and is not calculated on an individual account basis. None-the-less, just to be sure they don’t run afoul of the law, some DAFs may require that each account grant a minimum of 5 percent of its assets annually. This is something you should ask about because, if this isn’t required, it means that more of your donation can remain in the fund, with the potential to increase in value so that you have more to give away in the future. Of course, the main reason you would establish a DAF account is to support your favorite charities, so this might not be an issue for you.

Another factor that differentiates some donor-advised fund is how easily they can accommodate non-cash contributions. DAFs are a great way to get appreciated assets out of your estate, avoid paying capital gains tax and estate taxes on them, and get a tax deduction for the full amount.

For instance, say you own $1,000 worth of XYZ stock with a “basis” (original purchase price) of $400. This year, instead of writing your usual check to your favorite charity, you’d like to donate the stock. Problem is, your charity isn’t equipped to accept non-cash contributions.

If you sell the stock you’ll end up with less than $1,000 after you pay the brokerage charge and the tax due. Assuming you’ve owned these shares for at least a year, long-term capital gains tax will amount to $90 (15 percent x $600 profit). Both you and the charity lose because your contribution has been whittled down to around $900 or less. You get a smaller tax deduction and the charity ends up with less money.

On the other hand, in addition to cash, most donor-advised funds can accept contributions in the form of tangible property such as publicly-traded securities, jewelry, and works of art. A spokesperson for one DAF told me they’ve accepted donations of everything from real estate to a Greyhound bus to a seat on the Chicago Mercantile Exchange!

If you donate your appreciated stock to a donor-advised fund, you’ll get a tax deduction for the full fair market value, $1,000 in this example.(3) When the DAF sells the stock and invests the proceeds in your account, the sales price is not diminished by taxes because, as a charity, a DAF does not have to pay taxes. The sale will generate typical brokerage charges, so the amount that is credited to your account would be slightly reduced by these transaction fees. However, you’d have to pay these, anyway, if you sold the stock yourself. Once your account is funded, you can “advise” the trustees of your DAF to make a grant to your charity. With this approach, both you and the charity receive a bigger benefit.

If you’re contributing stock that is traded on a public exchange, it’s easy to determine the value of your shares. But don’t expect the folks who operate a donor-advised fund to know what your cabin on Lake Michigan is worth. The more esoteric your donation, the more likely a qualified, outside appraisal will be needed to determine the value of your contribution. Some DAFs require you to get the appraisal done, while others will take care of this for you. Keep in mind that a donor-advised fund can simply refuse to accept certain property; be sure to ask about this before you open your account if you think it’s going to be an issue.

Under federal law, there is an annual limit on how big a deduction you can take for making a charitable contribution. Whether it goes to a donor-advised fund account or directly to the charity of your choice, if your gift is in the form of cash, your maximum deduction is 50 percent of your adjusted gross income (AGI) per year. For all other assets, your deduction is limited to 30 percent of your AGI. However, you don’t lose the excess amounts. These are “carried forward” and can be deducted from future tax returns for up to five years.

Consider a donor-advised fund a “poor person’s private foundation.” You might not have the assets of the Rockefellers or Mellons, but for a fraction of the cost, you can create a legacy that supports the causes you believe in and teaches the value of giving to your children and future generations.

In fact, while the family’s gathered for Thanksgiving why not start a new tradition? First, open an account in a donor-advised fund. Then let adults and children alike know that while everyone’s enjoying their pumpkin pie you will accept recommendations for worthy causes. Each individual making a proposal would briefly explain why s/he thinks a particular charity is deserving of a donation. (This can include your church.) Then allow the family to vote on which organizations will receive grants from the family DAF account this year.

I applaud your generosity!
Gail

(1) Internal Revenue Code Section 501(c)(3), 509(a)(1), or 509(a)(3)
(2) Internal Revenue Code Section 4942(j)(3)
(3) Technically, the fair market value is determined by taking the average of the high and low prices the stock traded for on the day it was liquidated.

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.