An endowment works by taking a donor’s gift, investing it for the long term, and spending only a small share of the returns each year while leaving the original gift untouched. That structure is what lets a single donation support a scholarship, a faculty position, or a hospital program indefinitely. So when people ask how endowments work, the short answer is: the principal keeps earning, the institution spends a capped percentage of the earnings, and legal rules govern both sides of that equation.
The rest depends on what kind of endowment it is, what the donor said in writing, and which state and federal rules apply.
The Principal and How It’s Invested
Every endowment starts with the principal, sometimes called the corpus — the original value of the donor’s gift. The institution does not spend that money directly. It places the gift into a diversified investment portfolio designed to grow over decades.
A typical endowment portfolio holds a mix of domestic and international stocks, fixed-income bonds, and alternative assets such as real estate or private equity. The goal is to generate returns that outpace inflation while managing the risk of market downturns. Investment managers focus on long-term appreciation rather than short-term gains, because the fund is meant to exist far longer than any single market cycle.
Financial officers track the original gift value separately from accumulated investment earnings. That separation matters because many endowments carry legal restrictions on spending the original principal, while earnings above that amount may be available for distribution.
Three Types of Endowment Funds
Endowments fall into three categories based on how permanent they are and who set the restriction. The IRS recognizes all three for tax reporting purposes.
Permanent (True) Endowments
A permanent endowment is created by a donor who requires the principal to stay invested in perpetuity. Only the income and investment gains can be spent, and only for the purposes the donor specified. These funds carry the strongest restrictions and offer the highest level of long-term stability.
Term Endowments
A term endowment operates like a permanent endowment but with an expiration date. The donor restricts the principal for a set number of years or until a specific event occurs. Once that condition is met, the institution gains access to the full balance, including the original gift.1IRS. Instructions for Schedule D (Form 990)
Quasi-Endowments
A quasi-endowment is not created by a donor restriction. The institution’s governing board voluntarily sets aside money to function like an endowment. Because no external restriction exists, the board can reverse its decision and spend the principal at any time. These funds give institutions flexibility to respond to financial emergencies while still benefiting from long-term investment growth.1IRS. Instructions for Schedule D (Form 990)
How Much an Endowment Can Spend Each Year
Institutions do not draw down endowment earnings on an ad hoc basis. They follow a formal spending policy that caps annual distributions at a fixed percentage of the fund’s market value, typically calculated as a rolling average over three to five years. This smoothing prevents distributions from swinging with a single good or bad investment year.
The average effective spending rate for U.S. higher education endowments was 4.9 percent in fiscal year 2025, a slight increase from 4.8 percent the previous year.2NACUBO. U.S. Higher Education Endowments Report Stable Returns Most institutions target a rate between 4 and 5 percent, aiming to distribute enough to fund current operations while preserving the fund’s purchasing power against inflation.
Donor instructions determine how distributed funds can be used. A gift might be restricted to undergraduate scholarships, a named faculty position, medical research, or building maintenance. When the endowment earns more than the spending rate allows, the excess is reinvested into the principal, fueling future growth.
Underwater Endowments
An endowment becomes “underwater” when its current market value drops below the original gift amount, usually because of investment losses. Under the Uniform Prudent Management of Institutional Funds Act (UPMIFA), institutions are not automatically barred from spending on an underwater fund. Trustees may continue distributions if they determine the spending is prudent after weighing the fund’s purpose, general economic conditions, the effects of inflation, and the institution’s other financial resources.
Several states that adopted UPMIFA included an optional provision creating a rebuttable presumption that spending more than 7 percent of a fund’s value in a single year is imprudent. For this calculation, the fund’s value is determined by averaging at least quarterly valuations over three years. Spending below that threshold does not automatically create a presumption of prudence; it simply avoids the presumption of imprudence. If a donor’s original gift agreement specifies what types of income can be distributed, that specification overrides the general UPMIFA spending rules.
The Rules Trustees Must Follow
UPMIFA is the primary law governing how institutions invest and spend endowment assets. It has been adopted in 49 states and the District of Columbia. Pennsylvania is the only state that has not enacted it.
UPMIFA requires board members and trustees managing endowment funds to act in good faith and with the care of an ordinarily prudent person. When making investment and spending decisions, they must consider seven factors:
- Duration and preservation of the fund
- The purposes of the institution and of the fund
- General economic conditions
- The possible effect of inflation or deflation
- The expected total return from income and appreciation
- Other resources of the institution
- The institution’s investment policy
The same seven factors apply to both investment and spending decisions. Trustees document their reasoning to demonstrate compliance if challenged. Failing to follow these standards can lead to legal action or intervention by the state attorney general, who protects both donor intent and the public’s interest in charitable funds.
Changing a Donor’s Restriction
Restrictions on a permanent endowment are not always permanent in practice. If the original purpose of a gift becomes impossible, wasteful, or inconsistent with the institution’s charitable mission, UPMIFA provides two paths for modification. For smaller funds, generally those worth less than $25,000 where more than 20 years have passed since the gift, the institution can modify the restriction without court approval, provided it notifies the donor (if available) and uses the funds in a manner consistent with the donor’s original charitable intent.
For larger or newer funds, the institution must petition a court for modification under a process resembling the cy pres doctrine, which allows courts to redirect charitable funds to a similar purpose when the original one can no longer be fulfilled. The state attorney general receives notice of these petitions and may challenge or seek clarification before the court rules.
Tax Rules That Shape Endowments
Federal tax law shapes endowments from three directions: what donors can deduct, what large university endowments owe, and what private foundations must pay out each year.
Deductions for Donors
Donors who contribute to an endowment at a qualifying nonprofit, university, or hospital can deduct the gift on their federal income tax return. For cash contributions to public charities, which include most universities, hospitals, and religious organizations, the deduction is limited to 50 percent of the donor’s adjusted gross income for the tax year. Donations of appreciated property, such as stock that has gained value, are generally deductible at fair market value but subject to a lower ceiling of 30 percent of adjusted gross income.3Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts
Contributions to private foundations face tighter limits: 30 percent of adjusted gross income for cash and 20 percent for appreciated property. If a gift exceeds the applicable ceiling in a given year, the excess can be carried forward and deducted over the next five tax years.
Excise Tax on Large University Endowments
Beginning with the 2026 tax year, certain private colleges and universities face a tiered federal excise tax on their net investment income. An institution qualifies if it has at least 3,000 tuition-paying students, more than half of whom are located in the United States, and a student adjusted endowment of at least $500,000. The student adjusted endowment is calculated by dividing the fair market value of investment assets (excluding those used directly for the institution’s exempt purpose) by the number of students.4Office of the Law Revision Counsel. 26 USC 4968 – Excise Tax Based on Investment Income of Private Colleges and Universities
The rate depends on the size of the per-student endowment:
- 1.4 percent for a student adjusted endowment between $500,000 and $750,000
- 4 percent for a student adjusted endowment between $750,000 and $2,000,000
- 8 percent for a student adjusted endowment above $2,000,000
These tiered rates replaced a flat 1.4 percent rate that previously applied to all qualifying institutions.4Office of the Law Revision Counsel. 26 USC 4968 – Excise Tax Based on Investment Income of Private Colleges and Universities Public universities are not covered, and neither are small private colleges that fall below the thresholds.
Private Foundation Payout Requirement
Private foundations that hold endowment assets operate under a separate federal rule. Each year, a private foundation must distribute at least 5 percent of the average fair market value of its net investment assets for charitable purposes. This minimum investment return is calculated based on the fair market value of all foundation assets, excluding those used directly to carry out the foundation’s exempt purpose.5Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income
Foundations that fall short face an excise tax on the undistributed amount. Public charities have no federally mandated minimum payout; their spending rates are governed by their own institutional policies and by state law under UPMIFA.
Annual Reporting
Any tax-exempt organization that holds endowment funds must disclose detailed financial information on Schedule D of IRS Form 990, including beginning-of-year balances, new contributions, investment earnings and losses, amounts distributed, and administrative expenses. Organizations must also report the percentage of their total endowment held in each of the three fund types, which should total 100 percent.1IRS. Instructions for Schedule D (Form 990)
Starting a Named Endowment
Most institutions set minimum gift amounts to establish a named endowment, and the thresholds vary widely. A named scholarship endowment might require a minimum of $25,000 to $50,000 at many institutions, while an endowed faculty chair can require $1 million or more. Some organizations allow donors to build toward the minimum over several years through a pledge agreement.
The gift agreement is the legal document that defines how the endowment will operate. A well-drafted agreement addresses the purpose of the fund in language broad enough to remain relevant over decades, ties distributions to the institution’s spending policy “as it exists from time to time” so the rate can change without renegotiation, includes a flexibility clause letting the board redirect the fund to a similar purpose if the original purpose becomes impractical, and clarifies who has standing to enforce the agreement.
Donors who want their gift to last should keep the stated purpose general enough to accommodate changes in the institution’s programs over time. An endowment restricted to a department that is later merged or eliminated may require a costly legal modification. Discussing these scenarios with the institution’s development office before signing avoids complications decades later.