Mutual Funds in a Donor Advised Fund
Submitted by American Endowment Foundation on February 9th, 2016
By Peter McCrea
Mutual funds have become one of the most common asset types contributed to donor advised funds (DAFs).
Mutual funds provide a convenient, professionally-managed, diversified portfolio that would be complicated for most investors to manage on their own. They offer investors the ability to invest small or large amounts of money, even without much investing experience. They provide liquidity, automatic dividend reinvestment, and a variety of risk/return profiles.
However, there are some downsides to mutual funds. Some investors are surprised by the high fees embedded in actively managed funds, others are concerned that mutual fund share prices are calculated and shares can only be sold at the end of the trading day – which can be disastrous in a sudden crash.
However, the biggest complaint mutual fund shareholders have is that they can be taxed when the fund distributes gains it made from selling individual stock holdings within the fund – even when the shareholder has lost money on the investment. This is called “phantom gain”.
Phantom gain is common in a down market when investors sell out of a mutual fund that is dropping in value. In that case, the mutual fund management company often needs cash in order to pay the investors and might have to sell some profitable investments to generate it. Selling profitable investments creates a capital gain, which is taxable and gets passed along to all the fund investors – much to their aggravation.
If the fund has high turnover and sells holdings often, capital gains distributions could be an annual event. Therefore, shareholders might have tax liability without receiving the cash to pay it.
By donating mutual fund shares to a donor advised fund, capital gains taxes – both internal and external – and dividend income can be sheltered, and the donor receives a full fair market value tax write-off for the value of the shares.
If the mutual fund shares are sold once they are in the DAF, the donor’s investment advisor has flexibility to invest in an actively managed stock portfolio or a basket of ETFs, as well as alternatives such as private equity, hedge funds, real estate investment trusts, and commodities – all without concern for taxes. Lastly, in a DAF, advisors have no pressure to generate the 5% annual minimum required distribution as they would with a private foundation.
At American Endowment Foundation, we look forward to discussing your circumstances and helping determine the right path for you or your client. Contact us or call at 1-888-660-4508.