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Jun 30, 2021

Narwhal 101: Donor Advised Funds

Narwhal 101: Donor Advised Funds

Donor-Advised Funds: What are They and Should I Invest in One?

Although they have been around since the 1930s, donor-advised funds, or DAFs, have recently burst onto the scene as an increasingly popular vehicle for donating to charitable organizations. These funds are mostly being used by wealthy individuals to facilitate their large donations; however, many DAFs come with no minimum contribution and thus are accessible to anyone who wants to utilize them. Overall, the primary reason people use DAFs is for the immediate tax benefits they receive when they contribute to the account, but there are other benefits that we will also look at in detail. This article will attempt to provide a comprehensive description of DAFs by explaining what they are, how they are used, and why people use them.

What is a DAF?

A DAF is an account that allows an investor to donate assets such as cash, individual securities, mutual fund shares, and cryptocurrencies to public charities that qualify according to the IRS. Charitable donations made to a DAF are immediately tax-deductible, even if they are not given to a charity right away. These DAFs are commonly run by fund managers who invest the assets in the account in return for an investment fee. Once the investor contributes to the account, the fund managers will continue to invest the money until the investor decides to donate the money to a qualified charity.

How do I invest in a DAF?

If utilized properly, investing in a DAF can be a simple way to maximize the efficiency of your charitable donations. Here’s how you get started:

Step One: Find a Fiduciary and Compare Rates

DAFs are run by fiduciaries, or account managers, who will invest and manage your contributions for you until you decide to make distributions from the account to a charity (or charities) of your choice. This is similar to the way your retirement account is managed. In exchange for this helpful service, your fiduciary will charge a series of fees: investment fees, annual admin fees, and sometimes maintenance fees. It is important to research and compare these fees before choosing which fiduciary to set up your account with. Also, keep in mind that most fiduciaries will invest mostly in funds like ETFs and mutual funds, so there may be some hidden fees that you have to factor into the total cost of hiring an account management firm to manage your DAF. For more information on fees within funds, check out this article.

Step Two: Contribute to the Account

As mentioned before, there are a variety of assets that you can contribute to a DAF. You can, of course, contribute cash just like you would to your retirement account, but you can also contribute non-cash assets such as stocks, bonds, mutual fund shares, cryptocurrencies, life insurance, private equities, etc. It is important to note that all contributions to DAFs are irrevocable, meaning that once you contribute to the account, you cannot pull money out of it for personal use. All withdrawals from a DAF must be directly sent to an IRS-qualified public charity (see Step 5).

Step Three: Claim Your Tax Deduction Immediately

One of the main reasons that people invest in DAFs is that the contribution is immediately tax-deductible. This means that you do not have to wait until your contribution is donated to a charitable organization to receive a tax break. In order to claim this deduction on your taxes, you will need to itemize your deductions instead of taking the standard deduction. Before you do this, make sure that your itemized deduction will exceed your standard deduction, as there are some cases where it is still better to take the standard deduction.

Step Four: Grow Your Donation

Until you decide which charities you want to donate to, your assets will be invested by your fiduciary in the meantime. Although the fiduciary owns all final control over your assets once they are in your account, most DAF sponsors allow and even encourage you to recommend how you would like the money to be invested while it is sitting in your account.

Step Five: Donate to IRS-qualified Charities

Once you decide which charitable organizations that you want to give to, you can begin sending distributions to any organization that meets the requirements set by the IRS. Usually, your sponsor organization is responsible for making sure that your organization(s) meet these criteria. These can be one-time gifts, or you, typically, have the option to set up recurring distributions at your desired frequency.

Why Should I Invest in a DAF?

We have already touched on a few of the benefits that come with using a donor-advised fund to give to charitable organizations but let’s discuss the reasons to invest in DAFs in greater detail:

Tax benefits – The immediate tax deduction that you can claim for the year in which a contribution to a DAF was made can be a game-changer for your tax situation. First, it may be more beneficial for you to make one large donation and receive one large deduction than it would be for you to make several small donations over a span of several years and receive small deductions each year. If you have a year for which your tax liability is larger than usual, you have the option to basically prepay on your donations by contributing one large amount to your DAF instead of making smaller monthly distributions. That way you can immediately receive the total tax deduction that you would’ve received over, say, five years to help offset your unusually large liabilities. In addition to this benefit, you do not have to pay capital gains taxes on contributions to your DAF, and if you contribute assets other than cash, you usually receive a deduction equal to the market value of the asset, not the original purchase price.

Harnessing the power of time – Many people have the desire to give charitably but do not know where to start. As a result, they either do not give charitably at all, or they end up giving to an organization that they know nothing about just to receive the tax break. Neither is an effective investing strategy. When an investor is faced with this scenario, a DAF can help that person avoid wasting time and money. On one side of the scenario, a DAF allows investors who want to give charitably but do not yet know who they want to give it to capitalize on the time value of their money. When you give to a DAF, instead of your money sitting around waiting for you to decide what to do with it, it will be invested by your DAF sponsor until you are ready to donate it. On the other side of the scenario, you can use a DAF to receive an immediate tax deduction without having to give to a charity that you know nothing about.

Legacy Planning – Another benefit of investing in a DAF account is the ease at which you can set up an inheritor for the account after your death. By establishing a succession plan for your DAF, you can ensure that the charities you have supported your whole life will continue to receive distributions from your account even after your death. This can be an effective way to avoid a court deciding where your money should go after you die because you will have already made that decision yourself.

Bottom Line and Concluding Thoughts

A donor-advised fund can be an effective way to maximize the efficiency and tax benefits of your charitable donations, but it is important to understand that they are not for every investor. For example, it is a good general rule that you should not invest in a DAF for the sole purpose of receiving the tax benefits. There are better ways to chase a tax break. Unless you have already established (or intend to establish) a pattern of charitable giving, a DAF is probably not the right investment for you. Another reason why a person should avoid opening a DAF is if the majority of their charitable donations are to private foundations that do not fall under the IRS’s 501(c)(3) distinction for charitable organizations that are eligible to receive DAF grants. Political groups and crowdfunding campaigns are among these excluded groups. If you are thinking about opening a donor-advised fund account, please consult with your financial advisor or contact us at Narwhal to see if a DAF is a right investment for you.

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