The Difference Between Restricted and Unrestricted Funds

Nonprofit fundraising and finances are two very complex topics. However, it is important for all nonprofit leaders to have a solid understanding of both—particularly the difference between restricted and unrestricted funds.

This may sound confusing, but don’t stress. We will walk you through examples of both restricted and unrestricted funds so that you can decide which type is best for your organization–just keep reading!

Restricted funds are financial contributions a nonprofit receives that are set aside for a specific use. These funds are permanently restricted for that purpose and cannot be used for other expenses.

One important point about restricted funds is that they can only come about through designated giving. Individual donors can designate funds by restricting their donation to a specific purpose or program.

For example, a donor could make a donation via check to a local food bank. On the check memo line, they might write: to support youth feeding programs. That memo counts as a designation; that food bank must then use those funds to support youth feeding programs and cannot use them to support other programs or other indirect costs.

Similarly, foundations and corporations can restrict their giving through competitive grant programs.

Below is an example of a grant program that is restricted from a local community foundation. The grant program is for nonprofits who want to restore, maintain or repair historical structures in two specific counties in Pennsylvania.
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While a nonprofit can set aside portions of its general operating revenue to use for specific programs or projects, that doesn’t mean those funds are restricted in the legal sense. Funds are truly only restricted as the result of a donor giving specific instructions as to what the money may be used for.

Once funds are restricted, that restriction is permanent. Those funds cannot be reallocated or redirected for any other purpose. Nonprofits can face serious repercussions for using restricted funds for anything other than the designated purpose, including legal action and/or having to refund the donor.

Restricted funds are an important part of generating enough revenue to support specific programs, projects, and initiatives. However, restricted funds are not without challenges.

What if a donor makes a donation to your organization but they designate those funds to a purpose that does not make sense for your nonprofit?

For example, what if a donor makes a contribution to a nonprofit animal shelter and designates their funds to support veterinary care for farm animals. However, that particular shelter doesn’t serve or work with farm animals. If the shelter accepts the funds, the money is restricted to that purpose–period.

Here’s the good news: nonprofits are not required to accept designated gifts. If a donor gives with a designation that simply doesn't work, the organization can decline the gift or begin a conversation with the donor about using the funds for another purpose.

On the flip side, unrestricted funds are financial contributions that can be used in any way the nonprofit and its Board of Directors chooses.

Unrestricted funds are much less common than restricted funds, but they are important to a nonprofit’s financial standing as they can be used for items that are not directly program or project-related, such as general operating expenses.

General operating expenses can include things such as:

• Salaries
• Benefits
• Technology
• Training/professional development
• Rent
• Utilities
• Office supplies

Most restricted funds, such as grants for a specific program, will not cover these expenses, despite the fact that they are necessary for operations.

Nonprofits often ask for unrestricted funds when they solicit donors via direct mail or email. It is best practice to state that the funds you are soliciting are unrestricted on your donation form or formal acknowledgment letter.

There’s no easy answer to this question! Both restricted and unrestricted funds are important to a nonprofit’s financial makeup and have positive aspects. Below we have outlined some important considerations for each so that you can decide which is the best fit for your nonprofit at any given time.

Restricted Funds

Relationship Building: Restricted funds can help nonprofits build relationships. How? Because they give donors the assurance that their donation is being used in a way they are passionate about.

These gifts help your donors feel invested in your organization and your work. Also, since donors get to designate how their donation is being used, restricted donations can open the door to much larger gifts. This is good news!

New Programs & Projects: Restricted funds are also helpful in getting new programs off the ground. Many corporations and foundations have competitive grant cycles that are restricted to specific causes, such as climate, education, financial sustainability, etc.

Identifying these types of grant programs is a great way to generate revenue if a nonprofit is trying to get a new program off the ground.

Unrestricted Funds

Stability & Longevity: Since so many contributions are restricted, it is quite possible that an organization would find itself in a situation where they have plenty of financial support for their programs but no funds to pay their staff or rent.

Unrestricted donations help interrupt the “starvation cycle,” which is when nonprofits underspend on overhead expenses, otherwise known as indirect costs. These costs include salaries, recruitment/HR, technology, and training, which significantly impact an organization’s ability to offer high-quality programming.

Why is the starvation cycle a problem? Indirect costs are critical to a nonprofit’s infrastructure and directly impact an organization’s ability to operate well. If we’ve learned anything from the COVID-19 pandemic, it’s that the world is unpredictable—and nonprofits often need unrestricted funds to be able to respond to the constantly changing environment in their communities.

It also takes time to make an impact. When foundations, corporations, or individuals give unrestricted multi-year gifts, they support the organization's longevity. The most successful nonprofits are the ones that are able to build relationships, refine and reassess their programs, and continually reimagine their work as conditions evolve.

Recruitment & Staff Retention: It is challenging to recruit qualified candidates when a nonprofit can’t afford equitable salaries or health benefits for its staff. This leads to high rates of burnout and turnover.

In fact, a recent study by Forbes found that 45% of nonprofit employees plan to seek new employment in the next 3 years. Of those, 49% stated they plan to seek new employment because their nonprofit does not pay them well enough.

Unrestricted donations allow nonprofits to invest in their staff and leadership, breaking the cycle of overworking and burnout.

Effectiveness & Impact: Nonprofit organizations are working to tackle some very complex issues—homelessness, food insecurity, climate change, gun violence, etc. When a nonprofit has the power to direct funds to their programs as they see fit, it allows them to be responsive to the real needs cropping up in their respective areas.

For example, a nonprofit focused on climate change might want to allocate funds to respond to a current climate catastrophe; having access to unrestricted gifts will allow them to do this.

When donors designate or restrict their gifts to specific programs, it takes power away from the nonprofit to prioritize the needs they are identifying in their communities and among their constituencies. Unrestricted gifts let the needs drive action, which inevitably increases a nonprofit’s effectiveness and broadens its impact.

What does this all mean? A nonprofit receives two main types of funds from its donors: restricted and unrestricted. Restricted funds are designated for a specific purpose by the donor, which cannot be changed. These funds are more common—most grants and corporate donations will be restricted to specific purposes or programs.

Unrestricted funds can be used for whatever purpose the nonprofit deems necessary, including indirect or overhead costs. Unrestricted funds are much less common than restricted gifts, but the benefits are limitless. Unrestricted gifts support longevity, effectiveness, and even staff retention.

Understanding the differences between restricted and unrestricted funds will help you make strategic fundraising decisions for your nonprofit.