Sunday, December 9, 2007

Donor-Advised Funds

Some time ago I had a post on using ETFs to invest your money. In this post I'm going to write about a really convenient way to give away your money! I'm talking about Donor-Advised Funds (also known as Charitable Gift Trusts).

What are Donor-Advised Funds?

A Donor-Advised Fund (DAF) is like a charity: contributions to it can be deducted on your taxes in the same way that contributions to a charity can be deducted. You can open a DAF account at many brokerage firms (e.g., at Schwab, Vanguard, and Fidelity). Money contributed to your DAF is an irrevocable gift, i.e., it's not yours any more. However, you can advise the Fund management to make grants to charities that you select. While the final decision regarding such grants lies with the Fund management, they will follow your advice as long as the grant is to a registered US charity. (There are some minor caveats such as that the grant cannot fulfill a pledge you may have made to a charity; remember it's not your money any more.)

Why would one want to use Donor-Advised Funds?

There are lots of good reasons why DAFs make a lot of sense. Here are some that made sense to me:
  • Simplify stock or mutual fund donations
    Suppose you have a stock or mutual fund in which you currently have a significant long-term capital gain. For example, suppose the shares are currently worth $5,000 with a $2,000 long-term capital gain. Now, suppose you decided that you wanted to donate $5,000 to charity this year and get a tax deduction for the donation. You could sell these shares and donate the proceeds and deduct $5,000 on your taxes. But doing it this way, you'd still have to pay capital gains taxes on the $2,000. So what you want to do is to donate the shares themselves (without first selling them).

    But donating shares directly to a charity is a little complicated, specially if you want to donate to multiple charities. So instead, you donate the shares to your DAF, and then advise the DAF to donate the proceeds to the charities of your choice. It has exactly the same effect: you can deduct $5,000 and you don't pay capital gains taxes and you can distribute the money easily to as many charities as you like.

    This strategy is particularly useful when you consider donating shares of mutual funds that you built up over a long period of time using dollar cost averaging (DCA). While DCA may have got you some benefits, it also lands you in tax hell (you have to figure out the tax basis to compute the capital gains). If you donate shares in such a mutual fund (instead of cash), you instantly get rid of this tax hell.

  • Defer the decision on which charity to donate to
    It is the end of the year right now and you might be doing some tax planning. You may have decided to donate a certain amount to charity. But which charity should you donate to? With holidays coming up, you find you don't have the time to research the various causes. No problem: donate to your DAF now and decide on the actual charities later. That gives you the time to make the right charity choices, while getting you a tax deduction this year.

    Note that money donated to a DAF can be invested in a variety of mutual funds, ranging from money market funds, to bond funds, to stock funds. (Each DAF provides you with a list of choices.) So you can have your money grow inside the DAF before you finally advise the DAF to donate money to a charity.

  • Estate planning
    As part of your will or trust (you do have a will or trust, specially if you have children, don't you?!) you may have directed a portion of your estate to some charities. But as time passes you may want to change the charities to which you want to leave your money. Instead of having to go back and modify the will or trust, you can simply leave your money to your DAF. You can leave instructions for the DAF on what needs to be done with money contributed to the DAF once you're no more. And you can easily change these instructions.

  • Convenience
    Contributing to the DAF and having it disburse money to various charities is really very convenient. All these DAFs have good websites that allow you to contribute to the DAF, set up grants to charities, and get online reports on your account. You don't have to follow up with individual charities at the end of the year to get receipts---you only need the one receipt from the DAF. The convenience alone is worth a lot.
What are the costs?

For all the benefits outlined above, there are some costs. DAFs charge a small annual fee (Schawb's version charges 0.6% of assets or $100, which ever is larger). The capital gain tax savings alone can make up this fee.

All in all, Donor-Advised Funds are a convenient way to organize your charitable giving. If any of the above situations apply to you, I highly recommend you go to your brokerage firm and open a DAF account with them. It is most convenient to open the account with your own brokerage because it simplifies and speeds up the transfer of shares from your brokerage account to your DAF account.
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