A donor-advised fund, or DAF, is defined by the IRS as “a separately identified fund or account that is maintained and operated by a section 501(c)(3) organization, which is called a sponsoring organization. Each account is composed of contributions made by individual donors.” Funds are added to the account, and like an investment, the value will fluctuates based on the stock market. This gives donors the potential to grow their charitable giving over time. When the DAF increases in value or reports a gain, the gain is not taxable to the donor. The key benefit of investing in a DAF is that the donor does not incur taxes on the growth of their investment. This feature makes DAFs a great option for those looking to maximize their charitable contributions without the burden of additional taxes. Another benefit is that the donor can invest not only cash but also non-cash assets such as stocks, bonds, and real estate depending on the specific sponsoring organization, offering even more flexibility in how donations are made.
How Does a Donor-Advised Fund Work?
The mechanics of a donor-advised fund are relatively simple, but the possibilities for giving are vast. The money deposited and invested into a DAF must be used to donate to a certified charitable organization. The taxpayer can recommend which charitable organization will receive the donation, providing a sense of control over where their funds go. Once determined, the sponsoring organization retains final authority over whether to accept the recommendation. However, it is important to note that the taxpayer loses legal control over the funds once they are added to the account. This is an important distinction, as the fund is ultimately governed by the sponsoring organization. In other words, a DAF is a low-cost alternative to a private foundation.
How Does a Donor-Advised Fund Affect Your Tax Return?
If a taxpayer itemizes on their personal tax return (Form 1040), the DAF is a great way to increase charitable giving while simultaneously lowering taxable income. When itemizing, cash contributions made through a DAF will be deducted from the taxpayer’s taxable income. Keep in mind that there are limitations on charitable contributions including special limits on contributions to DAF’s in one tax year, so it’s important to seek advice from a CPA or accounting firm to ensure you stay within the legal guidelines and make the most of your charitable contributions.
A taxpayer can avoid selling securities or non-cash assets and reporting a capital gain by donating them directly to a DAF. By donating the securities directly to a DAF, the taxpayer can avoid the capital gains tax on the sale of securities. This can be particularly advantageous for individuals who have appreciated assets like stocks or real estate. As mentioned earlier, the fair market value of donated securities can be deducted from the donor's taxable income, up to 30% of adjusted gross income (AGI). Any amount that is limited during the year the donation is contributed to the DAF can be carried forward to future years. Any future appreciation—whether from dividends, interest, or further gains—while the securities are held within the DAF remains tax-free. Since the DAF is a tax-exempt entity, it does not pay taxes on these gains either. This makes donating appreciated securities to a DAF an effective way to maximize both charitable giving and tax savings. There is some control of itemized deductions when donating to charity as the state taxes are capped at $10,000, investing in a DAF is a good way to group donations. It will allow the donor to take a large charitable donation deduction in one year and then recommend distributions to your favorite charities over the next few years.
For corporations, charitable contributions are generally limited to 10% of the company’s taxable income for the year. In contrast, S corporations and partnerships are pass-through entities, meaning they do not pay income taxes at the corporate level. Instead, income and deductions pass through to the individual owners, who can then deduct their share of the donation on their personal tax returns based on their ownership percentage. This makes DAFs an especially attractive option for business owners who want to incorporate charitable giving into their overall tax strategy.
The Act of Giving
The most important aspect of a donor-advised fund is that it allows taxpayers to invest in charities, support growth and culture for future generations, and give back to those in need. A donor-advised fund allows for the donor to plan and track their charitable donations over time. A DAF opens doors for increased giving and provides taxpayers the opportunity to reflect on their priorities while making a difference in the lives of others.
As always, when engaging in tax planning or investing in a new fund working with an experienced financial advisor or tax professional can help you navigate more on donor-advised funds.
