Donor advised funds

In short

A friend of mine once gave a large gift to his church and felt proud until tax season, when he learned he had not planned well. You may be in a spot like his, with a good year of income and a wish to give well. A donor advised fund lets you put money in once and pick the charities over time. You take the tax deduction in the year you fund it, not the year the charities get paid. Once the money goes in, it belongs to the charity that sponsors the fund, and you cannot take it back. Check the deduction limits that apply to your income before you fund one.

The whole of it

What it is

I once watched a neighbor keep a coffee can on her shelf, marked "for giving." Whenever she felt moved, she dropped a few dollars in. When a friend in need came along, she reached for the can. A donor advised fund works a bit like that can, only it is run by a public charity, and the tax rules are much bigger.

You open an account with a sponsor. Community foundations, brokerage firm charities, and national nonprofits all serve as sponsors. You give money or other assets to the sponsor. The gift is final. In return, you get a tax receipt, and you get to recommend where the money goes later on.

Notice the word recommend. The sponsor holds legal control. In practice, sponsors follow the advice of donors. But you are advising, not commanding. That small difference is what the law rests on, and it is why the deduction is allowed.

If you have income that swings from year to year, this tool may suit you. A bonus, a stock sale, or a business payout can make one year far richer than the rest. You can give in that big year and spread out the actual gifts over many years.

How it works

If you are holding a decision about how to give, it helps to see the steps in order. First, you choose a sponsor and open an account. Second, you put in cash, or sometimes stock or other assets the sponsor accepts. Third, you claim your deduction on your tax return for that year, if you itemize. Fourth, over time, you send grant suggestions to the sponsor, and it pays approved charities.

The money in the account can be invested while it waits. Growth stays inside the fund and goes to charity. It does not come back to you. Sponsors charge fees, often a small percent of the balance each year, plus the cost of the investments you pick. Read the fee page before you sign. Fees eat into what reaches the charities you love.

Here is the part that catches folks. You only get a benefit from the deduction if you itemize. Itemizing means you list your gifts, mortgage interest, and certain taxes, rather than taking the standard deduction. Some people who give still take the standard deduction, and for them a gift changes nothing at tax time. That is worth knowing early.

Some people bunch several years of gifts into one year. They itemize that year, then take the standard deduction in the years after. The fund makes this easy, since you can put in a big sum once and pay charities slowly. It is a way of timing the deduction, and it is not a way of giving more.

The numbers, and where to find yours

I have learned that a plan is only as good as the numbers under it. So let me point you to the ones that matter, and tell you where to look them up rather than guess.

The first is the share of your income you may deduct for cash gifts to public charities. The law sets a ceiling as a percent of your adjusted gross income, which is the income figure near the bottom of the first page of your Form 1040. For cash gifts to a fund like this, the ceiling is the current figure, which the official source publishes each year of adjusted gross income. Gifts of stock held long term have their own ceiling, which is the current figure, which the official source publishes each year. Amounts above the ceiling can often be carried forward for the current figure, which the official source publishes each year years, according to IRS Publication 526, Charitable Contributions.

The second is the standard deduction, since it decides whether itemizing pays. For a single filer this year it is the current figure, which the official source publishes each year, and for married couples filing together it is the current figure, which the official source publishes each year. Your gifts and other itemized items need to beat that figure to matter.

The third is the minimum some sponsors ask to open an account. That is set by each sponsor, not by law. You will find it on the sponsor's own website. Tax rules for these funds are described in Internal Revenue Code Section 170 and in IRS Publication 526. Your own return will tell you your adjusted gross income.

A worked example

Let me tell you about Marcus, a director at a software company. Marcus is single. For this story, his adjusted gross income for the year is 300,000 dollars. The figures are plain and round so you can check every step. Your own number will come from your own return.

Marcus gives about 8,000 dollars a year to a food bank, a school, and a hospital. On his own, that would not beat his standard deduction, so he has never itemized. He wonders if a fund can help.

He decides to give three years of gifts in one year. Three times 8,000 dollars is 24,000 dollars. He puts 24,000 dollars in cash into a donor advised fund. Over the next three years, he recommends 8,000 dollars each year to his three charities.

Now the tax picture. Say Marcus's other itemized items, such as state taxes and mortgage interest, total 20,000 dollars. Add the 24,000 dollar gift, and his itemized total is 44,000 dollars. Suppose his standard deduction in my story is 15,000 dollars. He beats it by 29,000 dollars, since 44,000 minus 15,000 is 29,000. That extra 29,000 dollars comes off his taxable income.

Now the ceiling check. Say the cash limit in my story were 60 percent of adjusted gross income. Sixty percent of 300,000 dollars is 180,000 dollars. His 24,000 dollar gift sits far below that. No trouble there.

What is the tax saved? It depends on his bracket. Say Marcus is in a 35 percent bracket in my story. His saving on the extra 29,000 dollars is 29,000 times 0.35, which is 10,150 dollars. These figures are plain examples of mine, not current law, so you should check the real brackets and limits for your own year. In the next two years, Marcus takes the standard deduction and gives 8,000 dollars from the fund each year. The charities are paid on schedule. He got his deduction up front.

Where it goes wrong

I have seen good people trip over the same few stones, so let me name them kindly.

The first is treating the fund as your own pocket. The money is not yours once it goes in. You cannot pull it back for a roof repair or a tuition bill. If you might need it, do not put it in.

The second is giving when you do not itemize. If your gifts and other items do not beat the standard deduction, the tax benefit may be zero. That does not make giving wrong. It only means the fund will not save you money that year.

The third is forgetting the ceiling. Give more than the limit allows, and the extra waits for later years. You should know your number before you write the check.

The fourth is fees. A small yearly percent seems harmless. Over many years it adds up. Compare sponsors.

The fifth is trouble with the rules on benefits. IRS Publication 526 explains that a gift loses its deduction when you get something of value back. A fund cannot be used to pay a pledge you are bound to make, or to buy tickets to a dinner. Sponsors set their own rules on such grants, so ask before you send one.

The sixth is slow giving. Some people fund the account and then let it sit for years. Charities cannot spend a balance they never receive. A fund is meant to move money to work, so set yourself a rhythm.

Questions to answer before you leave this page

Have you looked at last year's return to see whether you itemized, and would this gift push you past the standard deduction? Do you know your adjusted gross income, and how a gift compares with the ceiling that applies to it? Are you sure you will not need this money back, since the gift cannot be undone? Have you read the fee page of the sponsor you are considering, and compared it with at least one other? Do you have a list of charities in mind, and a plan to send them grants over the coming years? Have you asked a tax professional to look at your whole year, including any bonus, stock sale, or business income that made this year different?