An endowment for a nonprofit is a permanent pool of donated money that stays invested while the organization spends only a small share of its returns each year, usually between 3.5% and 5% of the fund’s average market value. Understanding how endowments work for nonprofits comes down to three things: what kind of endowment it is, how the money can be spent, and the fiduciary rules — mostly set by state law under the Uniform Prudent Management of Institutional Funds Act (UPMIFA) — that govern every decision the board makes about it.
The original gift, called the principal, generally stays intact. Investment earnings fund programs. That structure gives the nonprofit predictable revenue that does not swing with each year’s fundraising results.
The Three Types of Endowment Funds
Not every fund a nonprofit labels an “endowment” carries the same restrictions. The rules differ depending on who imposed the restriction and what it says.
- Permanent (true) endowments. The donor requires the principal to remain invested indefinitely. Only investment income and gains can be spent, and only in line with the organization’s spending policy. The donor’s written instructions bind the nonprofit, which cannot override them without legal proceedings.
- Term endowments. The donor allows the principal to be spent after a specified period or triggering event — for example, holding the funds for twenty years before releasing them for a building project. Until that condition is met, the fund behaves like a permanent endowment.
- Quasi-endowments. The nonprofit’s own board sets aside unrestricted funds to function like an endowment. Because the board created the restriction, the board can also reverse it and spend the principal when circumstances warrant.
The distinction matters at every stage: which documents create the fund, how the money can be spent, what the IRS asks about on Form 990, and whether the board or a court has authority to change course.
How Endowments Are Funded
Cash is the simplest way to build an endowment. Many community foundations set a minimum initial contribution, commonly $25,000, so the fund produces enough income to justify administrative costs. Larger institutions may set higher thresholds.
Donors also transfer appreciated securities such as stocks or bonds. Giving the assets directly, rather than selling first, lets the donor claim a deduction for the full fair market value while avoiding capital gains tax on the appreciation. Real estate is another common source of endowment capital, though nonprofits typically run appraisals and environmental assessments before accepting property to confirm they can sell or manage it.
Testamentary bequests — assets directed to a nonprofit through a will or trust — often produce the largest single gifts because donors are transferring wealth they no longer need. Once the assets arrive, the nonprofit holds or converts them according to the donor’s instructions and its own investment policy.
Well-run organizations screen these gifts through a written gift acceptance policy. The policy spells out which types of property the organization will take and what due diligence is required, and it typically flags complex assets like closely held business interests or real estate for review by the board or designated officers before acceptance.
Tax Benefits for Donors
Individuals who contribute to a public charity’s endowment can generally deduct the gift on their federal income tax return. Cash contributions to a public charity are deductible up to 60% of the donor’s adjusted gross income in the year of the gift, with any excess carried forward for up to five additional years.1Internal Revenue Service. Charitable Contribution Deductions
Long-term appreciated property held more than a year offers a double benefit. The donor deducts the property’s current fair market value rather than what they paid, and neither the donor nor the nonprofit pays capital gains tax on the appreciation. The deduction for appreciated capital gain property donated to a public charity is limited to 30% of adjusted gross income, though donors can elect to use the 50% limit if they reduce the deduction to the property’s cost basis instead of its fair market value.2Internal Revenue Service. Publication 526 (2025), Charitable Contributions
How the Nonprofit Spends and Invests the Fund
Managing an endowment means balancing two goals that pull in different directions: preserving the principal for the long term and distributing enough income to fund current programs. Most nonprofits spend between 3.5% and 5% of the fund’s average market value, calculated over a rolling period of three to five years. Averaging smooths out market swings, so a single bad year does not force sharp budget cuts and a single strong year does not lead to unsustainable spending.
Some organizations set upper and lower bands as additional guardrails — for instance, never spending less than 3% or more than 6%. When returns exceed the spending rate, the excess is reinvested to grow the principal and protect purchasing power against inflation. During downturns, a nonprofit may reduce distributions temporarily to avoid eroding the base.
The Investment Policy Statement
Every endowment should be governed by a written Investment Policy Statement (IPS) that defines how assets are allocated among stocks, bonds, and alternative investments. The IPS sets targets (for example, 60% equities and 40% fixed income), outlines the organization’s risk tolerance and return objectives, and establishes rules for rebalancing when market movements push allocations off target. Many organizations fold their spending policy into the same document so investment strategy and distribution goals stay coordinated.
Legal Rules Under UPMIFA
Nearly every state has adopted the Uniform Prudent Management of Institutional Funds Act. UPMIFA provides the legal framework for how nonprofits invest and spend endowed assets, and it replaced older law that prohibited spending below the original gift amount.
Fiduciary Duties and the Seven Spending Factors
Board members and officers who oversee endowment funds are fiduciaries. They must act in good faith and with the care a reasonably prudent person in a similar position would exercise. When deciding how much to spend in any given year, the board must consider seven factors:
- The duration and preservation of the fund
- The charitable purposes the fund was created to support
- General economic conditions
- The possible effect of inflation or deflation
- The expected total return from investments
- Other resources available to the organization
- The organization’s investment policy
Underwater Endowments
An endowment is “underwater” when its current market value drops below the original gift amount, usually because of investment losses. Before UPMIFA, many states barred any spending from an underwater fund. UPMIFA allows the nonprofit to continue spending from an underwater endowment as long as the spending is prudent and consistent with the donor’s long-term intent. The board still has to weigh the seven factors, but a market decline no longer locks the fund automatically.
Modifying Donor Restrictions
Sometimes a donor’s restrictions become impractical — for example, if the fund supports a program the nonprofit no longer runs. UPMIFA provides two paths. For small, old funds, generally those valued at $50,000 or less that have existed for more than 20 years, the nonprofit can notify the state Attorney General of its intent to modify the restriction and proceed if the AG does not object within 60 days. For larger or newer funds, the organization must petition a court. Some states set their own thresholds and waiting periods.
Attorney General Oversight
State attorneys general are the primary regulators of charitable assets, including endowments. They can investigate whether a nonprofit is managing its endowed funds lawfully and in line with donor intent, and they can bring legal action against organizations that mismanage funds.3National Association of Attorneys General. Charities Regulation 101 Board members who breach their fiduciary duties may face personal liability or removal. Most states also require nonprofits to register with the AG’s office and file annual financial reports.
A Different Rule for Private Foundations
Private foundations play by a stricter federal rule that does not apply to public charities. They must distribute a minimum amount each year, based on 5% of the foundation’s net investment assets, or pay an excise tax. Qualifying distributions include grants to other charities, direct charitable expenditures, and reasonable administrative expenses tied to charitable activities. A private foundation that fails to distribute its required amount faces an initial excise tax of 30% on the undistributed income.4Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income Public charities have no equivalent federally mandated payout, which is why their spending rates come from internal policy.
IRS Reporting and Tax Considerations
Any nonprofit holding endowment funds reports detailed information on Schedule D (Part V) of Form 990. The disclosure covers beginning balances, contributions received, investment earnings and losses, amounts distributed for grants and scholarships, amounts spent on facilities and programs, administrative expenses, and year-end balances, for both the current and prior year.5Internal Revenue Service. Instructions for Schedule D (Form 990) The nonprofit must also break down what percentage of its total endowment sits in permanent, term, and board-designated funds; the three must total 100%. Assets held or administered by related or unrelated organizations must be disclosed as well.
Most passive investment income earned by a tax-exempt nonprofit — dividends, interest, and capital gains — is not taxable. But if the endowment holds property purchased with borrowed money, a proportional share of the income from that property may be treated as unrelated business taxable income. The taxable percentage equals the ratio of the outstanding debt to the property’s adjusted basis.6Office of the Law Revision Counsel. 26 U.S. Code 514 – Unrelated Debt-Financed Income Leveraged real estate and certain alternative investments deserve careful review with this rule in mind.
One additional tax hits a narrow slice of the sector. Beginning in 2026, private colleges and universities with large per-student endowments pay a tiered excise tax on net investment income: 1.4% for institutions with $500,000 to $750,000 per student, 4% for more than $750,000 up to $2,000,000 per student, and 8% above $2,000,000 per student. The tax applies only to private colleges and universities, not to other nonprofits.7Office of the Law Revision Counsel. 26 U.S. Code 4968 – Excise Tax Based on Investment Income of Private Colleges and Universities
Documentation That Establishes an Endowment
Every donor-restricted endowment starts with a gift instrument: the document that records the donor’s intent and the terms of the gift. It can be a signed letter, a formal gift agreement, or a clause in a will or trust. A well-drafted instrument names the fund, states the charitable purpose, and specifies whether the principal must remain permanent or can be spent under certain conditions. Vague instruments are a common source of later disputes with donors’ families.
Quasi-endowments have no external gift instrument because the board creates them. Instead, the board passes a formal resolution documenting why the funds are being set aside, their source, the intended use of investment income, and the conditions under which the board may withdraw the principal. That resolution is the legal record if the organization’s handling of the funds is ever questioned.
Beyond the initial documents, the nonprofit keeps files that track contributions, investment performance, distributions, and reinvestment of excess earnings. Those records support the annual Form 990 disclosures and demonstrate compliance with both donor restrictions and UPMIFA. They are also what protects the organization if the state Attorney General reviews the fund or a donor’s family challenges how the assets are being used.