Donor Advised Funds: What Are The Pros And Cons?

Posted by Billy Hufnell on January 27, 2022

Donor Advised Funds: What Are The Pros And Cons?

Supporting a cause you feel passionate about is a major financial objective for many Americans. Whether your budget for charitable giving is large or small, understanding the best way to donate your money can help you maximize your impact and minimize your tax bill. This is why it’s crucial to understand donor advised funds’ pros and cons before you explore this common charitable giving option.

In this article, we’ll explain the basics of donor advised funds and the tax benefits they can offer you. We’ll also cover the main pros and cons of these funds, and how they apply to various financial situations. Finally, we’ll touch on what you need to consider before you set up a donor advised fund, including the questions you should ask your financial advisor.

Are you looking for a financial plan that can help you meet your charitable giving objectives? Schedule a call with Bay Point Wealth to find out how we can help.

What is a donor advised fund?

A donor advised fund is a type of charitable account. As the donor, you open the account in your name and deposit money into it. The money is then held in custody by a nonprofit organization, enabling you to make donations from the fund to one or multiple 501(c)(3) charities at your discretion and on your timeline.

Donor Advised Funds: Pros And Cons

Donor Advised Funds: Pros And Cons - Bay Point Wealth

5 Advantages Of Donor Advised Funds

1. They’re not costly to set up.

You don't need a lot of capital to establish a donor advised fund. Unlike a private foundation (which can run you into the millions), you can create a donor advised fund with as little as $1,000.

2. They’re inexpensive to run.

The annual cost to run a donor advised fund is typically around 10 to 60 basis points, depending on the amount of money in your fund. This means if you put $1,000 dollars into the fund, it could cost your fund six dollars (60 basis points). Costs generally scale down the larger the gift deposited into the account is, or the more assets the fund holds.

3. Gifting is easy.

There are minimal administrative duties involved with making charitable gifts from a donor advised fund. Once you set it up, you’re good to go! You can even make electronic gifts easily to a large pre-approved list of 501(c)s.

4. Gifting timelines are flexible.

One of the biggest benefits of donor advised funds is that they don't require you to give money to a specific charity right away. This gives you the flexibility to make contributions when the time suits you—for example, in a particularly high tax year if you’ve received a bonus or sold a business, but haven't made the final decision about which cause you want to support. It’s important to think through your charitable decisions carefully and not rush the process.

5. Money grows tax-free.

The longer you leave your money in a donor advised fund, the more time it has to grow tax-free. You can select from a variety of investments such as cash to a blend of stocks and bonds to align with when you plan on withdrawing the money from the fund.

3 Disadvantages Of Donor Advised Funds

1. Gift types are limited.

Donor advised funds can usually only accept cash, stocks, and bonds as gifts. However, some are now also accepting real estate, offering donors more flexibility in their charitable planning.

2. Gift recipients are limited.

Once money has been put into a donor advised fund, you can only donate it to registered 501(c)(3) charities. As a reminder, once you’ve deposited the gift into your donor advised fund, that money can never be taken back for personal use.

3. It does not automatically continue past your death.

While donor advised funds do not automatically continue after you pass away, you can assign someone to manage the fund for you when you are gone. This could be an excellent way to get your children involved in charitable giving. However, it’s important for family members to understand that any contribution you make to a donor advised fund is irrevocable, so they will not be able to access the funds for other purposes.

Should you open a donor advised fund? What To Consider

When comparing donor advised funds’ pros and cons, the benefits outweigh the drawbacks. However, these funds may not be right for everyone. Let’s walk through a few things to consider before you set one up.

Who should consider donor advised funds?

Are donor advised funds a good idea? The answer could very well be yes, depending on your family’s priorities and financial circumstances.

They’re an ideal choice in the following situations:

  • If giving to charity is important to you and is a financial objective for your family.
  • If you have appreciated assets (e.g. a stock with a large unrealized capital gain).
  • If you want to coordinate large gifts during specific years so you can complete Roth conversions in retirement (we’ll explain this shortly).

The strategy of bunching can be a useful way of giving to charity, depending on a few different scenarios. For example, if you normally donate a total of $5,000 a year to charity, bunching would mean donating several years’ worth of your normal giving in the same tax year to help realize a certain tax benefit based on your financial situation. This will allow you to take full advantage of the annual tax deduction limits associated with charitable contributions. Here’s when bunching your gifts might make sense:

  • In the final year before you retire, when your income will substantially drop next year.
  • In a year where you want to accomplish larger Roth conversions (explained below).
  • In an unusually high tax year.

As another example, if you want to increase contributions to your Roth IRA account so you can withdraw more money from it tax-free down the road, a donor advised fund could be a great option. Say you’re retired and Social Security is your sole source of income, meaning your income tax is close to zero. Before you turn 72, you’d be wise to take some money out of your Individual Retirement Account (IRA) and put it into a Roth IRA to intentionally trigger tax. This is known as a Roth conversion. Making a large gift to a donor advised fund at the same time can enable you to contribute even more to your Roth IRA.

Who should avoid donor advised funds?

First and foremost, it never makes sense to give to charity solely for a tax break. On the flip side, it also isn’t the best idea to make a donation if you’re not going to receive any tax benefit whatsoever. This could be the case if your gift isn’t large enough to exceed the standard tax deduction.

For example, say the standard deduction ($25,900 in 2022 for a married couple) is greater than your total other deductions (commonly state and local tax deductions, and mortgage interest, for most couples). If you know your total deductions are only about $18,000, you would need to donate more than $8,000 to push you above the standard deduction and begin itemizing your deductions to see any real tax benefits from your gift.

In addition to asking yourself whether you truly want to donate to charity and whether you’ll get any tax benefit from doing so, you also need to be honest with yourself about whether you can afford it. There’s nothing wrong with holding off until some time in the future to prioritize your family’s other financial goals.

Questions To Ask Your Financial Advisor

To make your decision about creating a donor advised fund even simpler, here’s a short list of questions you can run by your financial advisor for insight:

  • Which assets would be best to contribute to a donor advised fund?
  • Does this level of contribution align with my overall financial plan?
  • Does it make sense to give to charity this year? If not, then when?
  • What tax benefit will I receive for the year for this gift?

A Personalized Charitable Giving Plan

At Bay Point Wealth, we recognize that everyone’s financial situation is different. Let us help you make the most of your charitable intent.

We’ll work together to ensure the gift you choose to give is the right amount and is well-timed for your current financial circumstances. We’ll also carefully consider the best source of funds to use for your gift. If you want to make a donation and complete a Roth conversion at the same time, our team of tax experts can also assist with that. Interested in learning more? Schedule a call with us today.

Schedule A Call - Bay Point Wealth

Topics: Financial Planning, Retirement Planning, Wealth Management