The Economics of Donor Advised Funds

Abstract

Donor advised funds (DAFs) are experiencing rapid growth because they are a cost efficient way for individual investors to receive an immediate tax deduction, while controlling the timing and disbursement levels of charitable gifts. As a result, the tax deduction on a DAF contribution can occur several years before the funds reach their charitable objective. Other charitable vehicles, much as private foundations or charitable remainder trusts, also realize this tax benefit, but these vehicles are more expensive to set up and monitor. Presently DAFs can be set up for donations as small as $5000. Even though donor advised funds can be preferable to private foundations, they may not be preferable to a “hold and give later” strategy that we call “checkbook philanthropy”. If other benefits of a donor advised fund, such as investment diversification and/or charitable due diligence, are not significant factors to the investor/taxpayer, then the choice between a donor advised fund and checkbook philanthropy centers on the interplay between the incremental DAF fees and the effective tax rate on the investments potentially held outside of a DAF. This article finds that a DAF is preferable to checkbook philanthropy whenever the incremental cost imposed by the DAF is less than the product of the investment’s return multiplied by the effective tax rate. If the incremental cost is greater than this product, then checkbook philanthropy is preferred. As long as tax rates are constant, the timing of a charitable deduction does not affect how much money is actually received by a 501(c)(3). We find that the same results occur whether the tax savings of the initial transfer to the DAF are reinvested for later donation or the tax savings are rolled into additional transfers to the DAF. Therefore, the key economic issue surrounding the use of DAFs is the relationship between the incremental DAF fees and the tax liability on investments held outside of the DAF.

Keywords: Philanthropy, Taxes, Donor Advised Funds

JEL Classification: D64, L3