While most people probably think of philanthropy as direct gifts to charities and nonprofit organizations, there are several financial vehicles that can help individuals make donations. One of the most prominent vehicles for people with significant wealth is a foundation. However, several other options are worth considering as well. Another potential option is a donor-advised fund, which offers some tax benefits and allows donations to be pooled and invested, potentially creating a larger impact.
With a donor-advised fund, money earmarked for contributions to 501(c)(3) public charities are invested by the fund for tax-free growth. Donors to these funds provide guidance on which charitable organizations should receive grants from the fund. Individuals can also choose how their donations are invested, so that their contribution can grow as they decide which charities they want to support. The initial donation to the fund is tax-deductible and all growth is free from any tax liability.
Donor-advised funds have been in operation since the 1930s, although the legal structure by which they now operate was not officially created by Congress until 1969. These funds have been growing in popularity since the 1990s, although the general public tends is less aware of them. In recent years, they have emerged as the fastest-growing vehicle for donations. Today, about 3 percent of all charitable gifts come from these funds. While donor-advised funds have some obvious benefits, they also pose some clear issues for the philanthropy sector.
When Are Donor-Advised Funds Appropriate?
People may choose to contribute to donor-advised funds rather than making a direct donation to a charity for a variety of reasons. For example, suppose that a wealthy individual has a very financially successful year and wants to support a few charities. These organizations are small and lack the infrastructure necessary to handle large donations effectively. By contributing to a donor-advised fund, the person can make five smaller grants instead of one large donation, with the added benefit of tax-free growth potential that could increase the impact of their donation.
In this situation, some people may suggest creating a private foundation, but this structure faces a 30-percent limitation for gifts and thus would not provide the same tax deductions as a donor-advised fund. In addition, private foundations require significant time and expense to establish and manage. On the other hand, a donor-advised fund is run by an entity that is technically classified as a public charity, although they are typically affiliated with major finance companies. The donor’s tax-deductible contribution is made to this entity, which then disburses grants to charities according to donor guidance. Donors should note that these entities are not obligated to follow their suggestions, although they have a strong incentive to do so—the resulting bad press would dissuade others from contributing to the fund.
The other major advantage of donor-advised funds is that the donation to the charity comes from the fund, not the individual. In this sense, the donation can be made anonymously, which is preferable for some donors.
What Are the Downsides of Donor-Advised Funds?
While donor-advised funds offer several benefits, they also have some downsides that philanthropists should consider. Perhaps the biggest issue with this type of vehicle is that it is not obligated to make a certain number of disbursements each year. Private foundations must distribute at least 5 percent of their assets each year, but donor-advised funds are not subject to this regulation. Sometimes, the managers of these funds encourage people to let their donations sit in the fund and grow, rather than grant them to charitable organizations. In this situation, the donor may begin to think of their gift as less as a donation and more as an asset that needs to be protected. As a result, the donor can become less likely to authorize the donation. Behavioral economists have coined the phrase “the endowment effect” to describe this behavior.
Individuals should keep in mind that the managers of donor-advised funds are not truly charitable foundations themselves, but rather organizations established by large financial management companies. For example, Fidelity Charitable is one of the largest recipients of donations as a donor-advised fund. However, $4.6 billion came into Fidelity Charitable in 2015, according to tax records, but only $2.8 billion was disbursed to charities. Altogether, Fidelity Charitable has about $15 billion under control. This sum essentially represents donations that are being kept away from charities that could benefit from them.
Donors have the ability to direct their investments in donor-advised funds and typically receive regular statements about how the investment is growing. These statements can encourage a feeling of ownership over the money, even though the donor won’t receive anything back and the funds are intended for charity. Ownership feelings lead to the endowment effect. The matter becomes even more complicated because donors can pass their accounts to children and grandchildren to create a charitable legacy. Donor-advised funds have an incentive to encourage hoarding behavior, because they can collect management fees for longer periods of time.
The Bottom Line
When it comes to donor-advised funds, the bottom line is that these vehicles have some serious tax advantages that can make them more appealing than other options, such as foundations. At the same time, individuals need to make sure that contributions to donor-advised funds are actually granted to charities. While it can be tempting to see how much the money can grow, funds that sit in an account will not make a real impact.