How Do Endowment Funds Work: Types, UPMIFA, and IRS Rules

An endowment fund works by taking a donated sum, keeping that principal invested in perpetuity, and paying out only a slice of the investment returns each year to support the organization’s mission. Most institutions target a payout between 4 and 5 percent of the fund’s average market value, drawn from earnings rather than the original gift. That structure is how endowment funds work across universities, hospitals, museums, and other nonprofits: the gift stays intact, the investments generate returns, and a controlled portion of those returns funds programs year after year.

The Two Layers: Principal and Earnings

Every endowment has two parts. The principal (sometimes called the corpus) is the donated money the institution has committed to preserve. The earnings layer is what the corpus generates through stock dividends, bond interest, and capital gains, and that is what the organization actually spends.

The document that governs both layers is the gift instrument, the written agreement between the donor and the institution. It spells out whether the gift is permanent or temporary, what the money can be used for, and any conditions the donor attaches. Fund managers have a legal duty to follow the donor’s intent as expressed there, and every investment and spending decision must stay inside those boundaries.

Investment growth beyond what is spent each year gets reinvested into the corpus. Over time this is what keeps the fund’s purchasing power steady against inflation.

Types of Endowment Funds

Endowments fall into a few categories depending on how long the principal must be preserved and who set the restriction.

Permanent endowments. The donor legally requires the principal to remain untouched forever. The institution can spend only from investment returns.
Term endowments. The donor allows the principal to be spent, but only after a set period passes or a specific event occurs. Until then, the fund behaves like a permanent one.
Quasi-endowments. The institution’s own board sets aside surplus funds and treats them as an endowment. Because no outside donor imposed the restriction, the board can reverse the decision and spend the principal when priorities shift.

Within any of those categories, a fund is also either restricted or unrestricted. A restricted endowment limits spending to a narrow purpose named in the gift instrument, such as a specific faculty chair, a scholarship with defined criteria, or a named research program. An unrestricted endowment lets the institution direct earnings wherever the need is greatest, including general operations and facility maintenance.

How the Money Is Invested

Endowment assets are managed either by an investment committee (usually a subcommittee of the board of trustees) or by professional third-party managers working under a formal investment policy statement. The policy statement sets the goals, authorized asset classes, risk tolerance, and performance benchmarks, and every manager involved has to follow it.

The investment committee builds and amends the overall strategy, hires and evaluates investment managers and consultants, and checks whether actual performance is tracking the stated objectives.¹ Many institutions bring in an outsourced chief investment officer to handle day-to-day portfolio management inside the boundaries the committee has set.²

Portfolios are diversified across traditional equities, fixed-income bonds, and alternative investments like private equity, hedge funds, and real estate. Spreading assets across classes reduces exposure to any single market sector. The target is a total return high enough to cover annual payouts, administrative costs, and inflation, while preserving the corpus for future generations.

How Much Gets Spent Each Year

The spending policy decides how much of the endowment’s value flows to the institution annually. Most organizations set a target rate between 4 and 5 percent of the fund’s market value.³ The rate is calibrated to provide meaningful annual support while leaving enough growth in the fund to preserve its purchasing power indefinitely.

To keep annual budgets from swinging with the stock market, institutions calculate the payout on a rolling average of the fund’s value, typically over three to five years rather than a single snapshot. A three-year rolling average is the most common. This smoothing means a sudden market dip does not immediately slash the programs the endowment supports, and a banner year does not create an unsustainable budget spike. Payouts are usually distributed quarterly or annually.

Administrative Fees

Institutions typically charge an administrative fee against the endowment to cover fundraising, donor relations, and investment management. The fee is separate from the spending payout and is usually assessed as a percentage of market value, often between 1 and 2 percent annually. Some institutions fold the administrative fee into their overall spending formula, so the combined payout and fee together make up the total draw.

The 7 Percent Presumption

Some states have adopted an optional provision from the Uniform Prudent Management of Institutional Funds Act (UPMIFA) that creates a rebuttable presumption of imprudent spending if an institution draws more than 7 percent of an endowment’s fair market value in a single year, calculated from the preceding three years’ average. It is not a hard cap. An institution can justify a higher draw when circumstances warrant, but exceeding the threshold shifts the burden onto the institution to prove the spending was prudent. Not every state has adopted the provision, and some apply a lower threshold for smaller funds.

When a Fund Goes Underwater

An endowment becomes “underwater” when its current market value drops below the original gift amount, usually because of investment losses during a downturn. Under UPMIFA, institutions can still spend from an underwater fund. They are not required to freeze all payouts, but the governing board must weigh seven factors before doing so:

The duration of the fund and the importance of preserving its long-term value.
The purposes of both the institution and the specific fund.
General economic conditions at the time.
The effect of inflation or deflation on purchasing power.
The expected total return from the fund’s investments going forward.
Other resources available to the institution.
The institution’s overall investment policy.

A board that decides to keep spending from an underwater fund should document its analysis of these factors in the meeting minutes, creating a written record that the decision was deliberate.

UPMIFA and Fiduciary Duties

UPMIFA is the primary legal framework governing how nonprofit endowments are invested and spent. It has been adopted in nearly every state and replaced the older Uniform Management of Institutional Funds Act, which dated to 1972. UPMIFA moved away from rigid historical-dollar-value floors toward a broader prudence standard, giving institutions more flexibility but requiring careful deliberation.

Every spending and investment decision must be made in good faith, with the care an ordinarily prudent person in a similar position would exercise. The same seven factors that apply to underwater funds apply to all spending decisions from any endowment.

Board members and trustees who oversee an endowment owe three core fiduciary duties. The duty of care requires informed, well-researched decisions: reviewing investment reports, understanding the spending policy, and asking questions before voting. The duty of loyalty requires acting solely in the institution’s interest, disclosing conflicts, and recusing from decisions where a personal stake exists. The duty of obedience requires that the fund continues to serve the purposes set out in the gift instrument and the organization’s charter.

Breaches carry real consequences. The state attorney general has broad authority over charitable assets and can investigate and bring enforcement actions against the institution or individual trustees. Trustees who mismanage endowment funds may be personally liable for restoring losses to the fund (a remedy called surcharge), removed from their positions, or barred from serving on nonprofit boards. Donors and their heirs may also have standing to sue in some states. Under the traditional common-law rule, only the attorney general could enforce charitable gift restrictions, but a growing number of states now give donors or their legal representatives the right to bring suit directly.

Changing Donor Restrictions

Circumstances change, and a purpose that made sense when a donor set up an endowment in 1950 may be impossible or impractical decades later. UPMIFA provides three pathways for modifying or releasing restrictions:

With donor consent. If the donor is alive and agrees, the institution can modify the restriction as long as the fund still serves a charitable purpose. No court approval is needed.
Court petition for administrative changes. If the donor cannot be reached or has died, the institution can ask a court to modify administrative restrictions (such as how the money is invested or held) when they have become impractical, wasteful, or harmful to the fund’s management.
Court petition for purpose changes. If the fund’s designated charitable purpose has become unlawful, impossible, impractical, or wasteful, the institution can petition a court to redirect the fund to a purpose that reasonably approximates what the donor originally intended. This is closely related to the older legal doctrine of cy pres.

The gift instrument itself can include a built-in process for modification. Donors who anticipate that circumstances may change sometimes include language allowing the institution to adjust the fund’s purpose without going to court, which can save both sides considerable time and expense later on.

IRS Reporting

Nonprofits that hold endowment funds must report detailed information to the IRS each year. Any organization filing Form 990 that maintains endowment assets has to complete Part V of Schedule D, which requires disclosure of:

Financial activity: beginning-of-year balance, new contributions, net investment earnings and losses, amounts distributed for grants or scholarships, spending on facilities and programs, administrative expenses, and end-of-year balance, reported for the current year and four prior years.⁴
Fund classification: the estimated percentage of total endowment funds held as board-designated (quasi-endowment), permanent endowment, and term endowment, totaling 100 percent.
Third-party holdings: whether any endowment funds are held and administered by unrelated or related organizations.
Intended uses: a written description of what the organization’s endowment funds are meant to support.

Filing incorrect or incomplete returns triggers penalties, starting at a base of $250 per return with an annual maximum of $3 million, and reaching higher amounts for intentional disregard.⁵ These amounts are adjusted for inflation each year.

Excise Tax on Large University Endowments

For tax years beginning after December 31, 2025, certain private colleges and universities face a federal excise tax on their net investment income under 26 U.S.C. § 4968. The rate depends on the institution’s “student adjusted endowment,” calculated by dividing the fair market value of the institution’s non-exempt-use assets by the number of students enrolled.⁶

The tiered rates for 2026 are:

1.4 percent for institutions with a student adjusted endowment of at least $500,000 but no more than $750,000.
4 percent for institutions above $750,000 but no more than $2,000,000.
8 percent for institutions above $2,000,000.

These rates, enacted by amendments effective July 4, 2025, replaced a prior flat rate of 1.4 percent and imposed progressively higher taxes on institutions with the largest per-student endowments.⁶ The tax applies only to certain private colleges and universities meeting the statute’s thresholds, not to nonprofit endowments generally.

Setting Up a New Endowment

A new endowment starts with the gift instrument, which defines the fund’s purpose, any restrictions on how earnings can be spent, and whether the endowment is permanent or has a defined term. A well-drafted instrument protects both the donor’s intent and the institution’s ability to manage the fund over the long term. It should address not only the initial purpose but also what happens if that purpose later becomes impractical, since a modification clause can spare both parties the cost and delay of a court petition decades on.

Most institutions set minimum gift amounts for named endowments. Thresholds vary widely, but the reasoning is the same: the fund has to be large enough for its annual payout to be meaningful. At a 5 percent spending rate, a $25,000 endowment generates roughly $1,250 per year, enough for a modest scholarship but not a faculty position. Named professorships and faculty chairs often require gifts of $500,000 to $3 million or more. Many institutions let donors build toward the minimum through a series of pledged contributions, with the fund becoming a full endowment once the threshold is met.

The fund’s classification as permanent, term, or quasi should be documented clearly in the gift instrument, because it determines the legal restrictions on both spending and reporting. Once established, the fund appears on the institution’s Form 990 Schedule D and is subject to the same investment policies, spending rules, and fiduciary oversight that apply to the rest of the endowment.

1
Marquette University. Investment Policy Statement Pooled Endowment Funds
2
St. Olaf College Finance Office. Investment Policy and Objectives for Endowment Assets
3
Urban Institute. Income from Endowments
4
IRS.gov. Instructions for Schedule D (Form 990)
5
eCFR. 26 CFR 301.6721-1 – Failure to File Correct Information Returns
6
Office of the Law Revision Counsel. 26 USC 4968 – Excise Tax Based on Investment Income of Private Colleges and Universities