Morningstar - Q3 2021 - 57

Strategies
Pros and Cons of Donor-Advised Funds
Donors benefit from an immediate
tax deduction, tax-free growth, and
investment flexibility.
DONOR
Amy C. Arnott
President Joe Biden's proposed tax-law changes
have many investors wondering about how
to adjust their portfolios to minimize the impact.
In addition to potential increases in income
tax rates and the maximum tax on capital gains,
one proposal involves limiting the step-up in basis
for inherited assets. Under current tax law, the
cost basis of inherited assets generally " steps up "
upon the original owner's death, meaning
the beneficiary will only pay taxes on any gains
over and above the stepped-up value. Biden
has proposed limiting this benefit to $1 million
per individual or $2 million per couple.
In addition, the 2018 tax-law changes make it
more difficult to claim a charitable deduction.
Because most investors now take the standard
deduction instead of itemizing, it can be beneficial
to " bunch " charitable donations by making
a larger donation in a single year, which might
push investors past the threshold for itemized
deductions, instead of making smaller annual
donations that might not be tax-deductible.
Donor-advised funds can facilitate this strategy
because donors can make a bigger contribution
to a donor-advised fund in a single year and
take the itemized deduction up front but still make
charitable contributions over time.
For both of these reasons, donor-advised funds
are worth considering. In this article, I'll cover
some of the basics of donor-advised funds.
The Basics of Donor-Advised Funds
A donor-advised fund is a vehicle that allows
investors to donate directly to a charitable
fund but retain control over the assets. Donoradvised
fund administrators are public charities
that qualify as section 501(c)(3) organizations.
That means donors can benefit from an immediate
tax deduction when they contribute cash or
other assets to the fund. Although contributions
are irrevocable (meaning investors can't withdraw
donations if they change their mind or need
extra cash), the donor retains control over how
to invest the assets and how much to contribute
to various charities over time. Any remaining
assets benefit from tax-free growth as long as the
account remains funded.
Donor-advised funds have become increasingly
popular in recent years. The National Philanthropic
Trust estimates that assets in these funds totaled
about $142 billion as of the end of 2019. There
are several main types of donor-advised funds:
those administered by a specific charity directly;
those administered by a community foundation or
religious organization (such as Jewish United
Fund or Catholic Charities); and those administered
by an organization connected with a financial
institution, such as Fidelity, Schwab, or Vanguard.
In this article, I'll focus on the third category,
but the other two types are broadly similar.
The Pros
The major benefit of donor-advised funds is the
ability to take an immediate tax deduction
on the amount contributed. Donors contributing
cash can take a deduction of up to 60% of
adjusted gross income. (Individuals can deduct up
to 100% of adjusted gross income in 2021 for
donations made directly to qualified charitable
organizations under the Consolidated
Appropriations Act, but this is a temporary limit
that doesn't apply to donor-advised funds.)
Donors can also contribute a wide range
of appreciated assets, including stocks, bonds,
mutual funds, privately held business interests,
restricted stock, and even bitcoin. Donors
contributing securities or other assets can take a
deduction of up to 30% of adjusted gross income.
The in-kind tax deduction can be especially
valuable for highly appreciated assets because it
allows investors to remove these assets from their
taxable portfolios (thereby improving diversification
and mitigating security-specific risk) without
taking the tax hit associated with the embedded
capital gain. The donor-advised fund takes
care of selling the appreciated asset, but there's
no realized capital gain to report.
Contributors to a donor-advised fund also
retain full control over when and where to make
charitable donations. Accountholders can
make donations all at once or over time, and
to a single charity or a variety of charitable
organizations. The main requirement is that
donations go to a qualified charitable organization.
Each donor-advised fund sets its own minimum
amount for grants to charities; Fidelity and
Schwab currently have $50 minimums, while
Vanguard requires a $500 minimum grant.
Donors also retain control over how the
remaining assets are invested. Investors can
typically choose from several preset investment
options with different risk levels, ranging
from conservative, bond-heavy portfolios to
more-aggressive, equity-oriented portfolios.
Investors can either choose one of these
preset portfolios or build their own portfolios using
a longer list of single asset-class options. It's
also possible to set aside some funds for upcoming
donations in highly liquid securities (such
as a money market fund) while investing other
assets for longer-term growth.
The Cons
Despite their advantages, donor-advised funds
aren't the right choice for everyone. Although
Schwab and Fidelity now allow investors to set up
a donor-advised fund with any dollar amount,
Vanguard Charitable requires a $25,000 initial
contribution. Donor-advised funds also come
with an additional layer of annual administrative
costs. Fidelity, Vanguard, and Schwab all
charge a 0.6% administrative fee for accounts with
morningstar.com/lp/magazine
57
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