I am a massive fan of the Donor Advised Fund or DAF, and I think it is an underutilized financial planning tool. And I hope to play some small part in changing that. If you are a candidate for using a DAF, there are a couple of amazing superpowers that DAF offers: the ability to shift time, the ability to make capital gains disappear, and the ability to simplify your life.
Are you a candidate to use a DAF?
There are two categories of people who should consider a DAF. The first is anyone who is charitably inclined, and the second is anyone who does not identify as charitably inclined but wants to tap into the tax advantages of being charitably inclined.
By way of personal example, my wife and I have an aspirational target of setting aside 10% of our annual income for charity each year. I call this an aspirational goal because we seem to get close every year, but something inevitably seems to come up that interferes with that goal - the need for a new car, a tuition payment, and a tax bill. Our charitable inclinations are run-of-the-mill and include our church, a local food bank, water.org, an orphanage, and similar organizations. A private foundation might be a better route if you have higher aspirations, usually starting above $1,000,000 of assets. More important than that threshold is your charitable intent. If you want to give grants directly to fund medical research, install solar systems that directly benefit underprivileged populations, or fund research into a new generation of toilets, then you will likely need a foundation to further that work.
The second category of people that could benefit from a DAF is someone who wants to minimize their tax bill. The higher your marginal tax rate, the more benefit you receive from every dollar of charitable donation made in the form of tax savings. Whenever someone asks me how to reduce their tax burden, one of the questions I ask in response is if they are charitably inclined. This can be especially true in a year when there is a large windfall, such as a liquidity event, selling a home, or are considering exiting a stock position with a significant unrealized capital gain.
Where can I hold a DAF?
When getting started and trying to keep things as simple as possible, it is often easiest to open a DAF where your existing brokerage relationship is. I have personally used Schwab Charitable and Fidelity Charitable, and both are easy to set up, easy to make contributions to, and easy to requisition donations from.
If your interests go beyond vanilla investing needs, have objectives beyond direct investments to charities, or are illiquid in nature, there are plenty of different options for you. For example, Impact Assets has an excellent reputation if you want your DAF to have an ESG tilt or be able to make more direct impact investments.
How does the DAF work?
In short, a DAF acts as a conduit for your charitable donation. In the eyes of the IRS, the DAF is a charity, and therefore you get credit from the IRS for your donation to the DAF. In the language of tax and estate planning, the contribution to the DAF is deemed to be a "completed gift," meaning that it has left your estate, is not in your direct control and is irreversible. The DAF holds onto the funds until you are ready to "recommend" distribution to the end charity. The first two words of DAF are "donor-advised" and mean that the administrator of the DAF will take your distribution request under advisement. The DAF administrator must research the request and distribute the funds should the charity meet specific criteria. Using Schwab Charitable as an example, the requirements are that the receiving charity must be a 503(c)(3) charity in good standing and must complete a form to validate their status as a 503(c)(3), including validating mailing address and contact information.
How do you fund a DAF?
There are a couple of ways to donate money to your DAF. The simplest but least tax-advantageous is a direct cash donation. While you receive the full applicable charitable tax deduction (check with your tax professional on applicable limits), there might be a more advantageous way to contribute.
A second method, and the most commonly discussed method, is the contribution of a highly appreciated asset such as a stock you own. I have a client who worked at a very successful tech company well before the IPO. The cost basis of that holding is well below $1 per share, which as of this writing, represents 261,458% gain. Each share would effectively be 100% gain and therefore 100% taxable when sold. In selling, approximately one-third of the sale price would go to pay Federal, State, and ACA tax (your rate may vary, check with your tax professional). However, an alternative would be to contribute this holding to a DAF, thereby avoiding the tax on a sale, and the client would receive a full tax credit for the donation (assuming IRS limits).
A third method, which may apply to far more people, is to contribute slightly appreciated assets to a DAF. By way of example, my wife receives an annual bonus at work every year. We look forward to that bonus to hit some financial goals, usually in trying to get to that 10% charitable goal. Like most people, we don't own any stock that has appreciated as much as the previous example, but we do have some holdings that have appreciated 10% or more. For the sake of argument, assume that we want to donate $10,000 to our DAF. I could donate that money directly from the cash we have from the bonus payout. Instead, I choose to take a holding of equivalent value and donate those slightly appreciated shares directly to the DAF. Suppose the cost basis of the $10,000 stock holding is $8,000, representing a 25% increase in value and the avoidance of about $800 in taxes if I were to sell. I then take the $10,000 I have in cash, and I buy the same holding the next day. That way, my portfolio is structured exactly the same as before the donation, I donated $10,000 to charity for which I receive a tax deduction, and the "cost basis" of my portfolio has been increased, which effectively will reduce my future tax bill.
How does the DAF help shift time?
One great aspect of the DAF is that it allows you to separate the taxable event from the eventual charity receiving the funds. I provide two examples of how this might play out.
First, I have a client who has identified a charitable target they are trying to hit per year. In their particular situation, the annual donated amount would not affect their tax rate because the standard deduction is larger than their deductions in a given year. As a creative way to work around this, we decided to contribute to the DAF every other year, creating a larger itemized tax deduction. Through the DAF, the charities that the client supported received regular donations and was never aware of the "lumpy" contributions to the DAF.
Second, I have a client who received an unexpected (and highly taxed) cash windfall. This client wanted to reduce their taxable bill. In talking through their options, they struggled to identify enough individual charities they wanted to support in the form of one-time lump sum contributions. What they chose to do instead was to make a significant contribution to their DAF, reducing their tax bill in the year with the highest impact. This gave them the time to carefully consider where the funds would be distributed over many years.
Is a DAF simpler than direct donations?
If you have ever been frustrated at tax time by the need to track down many charitable receipts, you may benefit from a DAF. I can recall a year not too long ago when I was utterly unprepared for tax season, and I had simply failed to keep track of my charitable donations. I found myself scouring my PayPal account (preferred by my children's school), my bank account for ACH payments (my church), gifts made by check (a few one-off contributions), and donations made by credit card (Relay For Life, Team in Training). I'm still not positive that I found them all.
Based on this experience, I decided to open a DAF, think about creative ways to make contributions, and then funnel all my contributions through the DAF. Instead of a potpourri of donations methods and receipts, I now typically have one or two receipts to track, which are the contributions I make to the DAF. I think the DAF saves me hours of work and makes tax time easier, simpler, and less stressful.
What about the superpowers?
As mentioned earlier, the DAF has three superpowers:
- The ability to shift time.
- The ability to make capital gains disappear.
- The ability to simplify your life.
Any one of those three alone is a compelling reason to consider using a DAF, but it becomes a highly compelling tool when you combine all three. I know the DAF has been a powerful tool for my household, as well as those of my clients.
Disclosures: Context Wealth, nor any of its members, are tax accountants, and do not provide tax advice. For tax advice, you should consult your tax professional. Investment advisory services offered through Mutual Advisors LLC DBA Context Wealth, an SEC registered investment adviser.