Approaching Donor-Advised Funds – Change Your Perspective

Several years ago I had come across Donor-Advised Funds (DAF) as one avenue to do charitable giving in the mid/late career phase. It occurred to me that the mechanics of a DAF can be configured to parallel in many respects the aims of people like me that try to center their own lives and ideally their communities around sustainable trajectories. There are some tactics to alter how we might value setting up a DAF that might encourage more people to follow this path. I may have approached my DAF differently if I had learned about some strategies sooner, perhaps even as early as 5-10 years before implementing one. For those of you in high tax brackets and still with a healthy set of deductions to itemize, a DAF can be especially advantageous. So if it helps, here are several considerations to ponder well in advance.

Think several moves ahead

The Stewardship Perspective Hack

The basic mechanics of a DAF might be described as “tax benefits now, giving later”. You set up a DAF through an organization like Vanguard Charitable, fund it with a contribution to at least their minimum level ($25,000 in the case of Vanguard), and then you receive the tax deduction in that year. You no longer “own” the assets, but can act as the custodian/steward of the fund, to later direct grants from it to qualified 501(c)(3) charities. The DAF can be invested in assets like mutual funds until you decide to make your grants.

So the first “perspective hack” that can be applied to a DAF is to re-frame the concept of ownership/stewardship. One might think “but if you put money into a DAF, you won’t be able to get it out, if you need it.” Well, don’t fund it with money you think you will need desperately – but in your 40s and 50s, ideally you will be on a trajectory that will provide you with more than enough to meet your needs, and you will be looking for opportunities then and later in life to distribute some portion of your lifeforce to worthy causes.

The second perspective hack is to consider what sort of steward you are for all your assets, and realize that your holdings in a DAF are really no different. You don’t truly and permanently own your “real” bank or mutual fund accounts; they are gifts that the universe has allowed you to exercise control over for various purposes for a limited time. So really, a DAF is similar – an asset for which you are a steward; just that your choices of how to direct them are more constrained. If, like me, you have a Smaug-like tendency, then treat the DAF as another account in your total net worth calculation. They just live in their own partition.

Now to the third perspective hack – giving to a DAF can actually increase your net worth. If you accept that you essentially retain stewardship over the DAF, then your contribution of, say $25,000 in Year One (which has no net impact on your net worth, being simply a shift from one account to another) and the income deduction may effectively boost your tax refund by some 30+%. You would then realize in Year Two an ~$8000 “dividend” on your tax return. You could invest that in other ways as you like, or roll it into your DAF, which would then trigger another ~$2400 Year Three dividend, which could be repeated ad infinitum for an interesting infinite series problem. Thus your psychological adjustment to encompassing stewardship of the fund as part of your holdings could actually accelerate your net worth accumulation curve, with the proper accounting and perception.

Thinking Well in Advance

You likely want to harvest what tax advantages you can from your giving, as surely you will direct your grants more wisely than the government would. So think about when, how, and how much to give well in advance of the time in your life when your tax bracket may fall off dramatically. This means you, well-compensated-for-now-but-pondering-early-retirement types. Instead of experiencing an earned income “cliff”, use some of those high-salary, pre-retirement years to sock away some assets in a DAF generously to reshape your glide path curve, so that you can then spend more of your quality later years figuring out how to continue your generosity through to the end recipient. This is doubly important for those that may be considering paying off their home early – if you do not feel you will have many other itemized deductions after the home is paid for, it may make sense to fund the DAF while you are still itemizing. Thus, ponder this many years in advance of a (planned) major shift in tax situation.

N.B. I am not a tax expert, just a simple engineer.

In my case, with a paid-off home and nothing else complicated going on, my plan is to add funds to the DAF with larger contributions in alternate (even numbered) years, so that in the intervening ones (odd numbered) with no contributions into the DAF, I could go ahead and take a standard deduction. Mathematically this should come out a bit ahead versus level contributions every year.

Feel a little bad about gaming this since then in theory one should also plan to donate physical items to the e.g. animal shelter or library only on the same even numbered years, but that is small change, so I’ll keep donating stuff for the dogs if it helps keep the house tidier.

You also may prefer to make contributions to the DAF from appreciated assets, such that you can avoid capital gains on them. Thus the situation may arise where you are donating mutual funds to the DAF with one hand, and buying similar funds in non-retirement accounts with after-tax cash savings with the other hand, for little instantaneous effect on net worth, but increasing your cost basis on the funds held outside the DAF.

DAF Management as Selfish Practice for Retirement

So let’s say you have funded your DAF with a >=$25,000 “kick-start”, now what? Well, especially for those FIRE types that may be executing this several years in advance of retirement, start practicing. Try applying the 4% rule, and at the start of every year, review the DAF balance, take 4%, and decide on that as your charitable grant total for the year. Divide that by the minimum charitable contribution you are able to make from the DAF (in Vanguard’s case it is $500), and in that example, the $1,000 would allow for up to two grants for that year. If you find the DAF isn’t very sustainable on 4% given your selection of assets, hm, well, better to learn that practicing with a DAF before you take the early retirement plunge.

The following Table shows a simple illustration of the strategy. Assume you make the grant quantity for the year decision in January based on the existing balance, prior to any additional contributions into the DAF. Let’s say additional contributions get made in January also, to keep the math simple. Assume the DAF sees a 6% annual return, and that the grants are made in the charitable month of December (also for easy math). We throw a few $10k contributions into the fund in alternate years to get rolling, and voila! – over these five years the DAF has thrown off $7k in grants, while the total grew to $50k, which enables us to move to as frequent as quarterly grants. This path would be a quick jump start to building a flexible and sustainable giving mechanism for your future, even if your income/taxation level falls off significantly after that point.

Cultivate Stewards not Wastrels

$25k is the initial minimum for Vanguard Charitable, with $5k minimum contributions. If one can get the DAF balance up to multiples of $25k, then there is more flexibility in legacy options. Vanguard allows one to name successor custodian/stewards. If you want to ‘split’ your DAF, the minimum balance per custodian is $25k. So $50k under our scenario would allow you bequeath it on your passing to up to two custodians, such as friends or relatives.

No doubt many of us want to help out family or friends while we are still alive, and we should, in appropriate manners. Most of us would like to leave inheritances also for worthy folks. However, once the money is distributed, the memory of the gift probably fades in time, and the funds may or may not get put to a higher purpose. If some percentage of your net worth is in DAFs, and you can pass custodianship on to suitable stewards in parallel with standard inheritances, then perhaps you have set up something sustainable that will continue to work in a virtuous manner well after you check out. Or not – no guarantees. Still, asking someone to manage assets for a higher purpose seems like it would be character-enhancing, and hopefully they might follow your founding principles, if you were wise in selecting them in the first place.

Summary

DAFs seem to have a host of useful features. The psychological tricks regarding net worth, the practice in applying the 4% rule, the creation of a useful diversion for your retirement time, the potential establishment of long-term legacies – multiple benefits from this tool. DAFs aren’t a bad place to stash periodic or windfall ‘giving’ allocations such as agnostic ‘tithes’, even if you don’t know yet who the end recipient will be. Worst case, if you or your heirs get tired of managing the DAF sustainably, you could always grant the entire balance to a decent  501(c)(3) and move on to some other avenue for your giving.

A fine article with far more detail on the mechanics can be found here. Given the tax impacts, as earlier stated it seems DAFs are worth investigating several years before you might find one appropriate for your situation.