What are Restricted Funds and How Do I Manage Them?

Restricted funds are donations or grants that come with specific conditions set by the donor. These conditions legally require the nonprofit to use the money only for the stated purpose or within a set timeframe. For example, a donor might give $50,000 that must be used to fund scholarships, launch a new community program, or support an endowment. Because the restrictions are binding, misusing restricted funds can lead to loss of donor trust, compliance violations, or even legal consequences.

Restricted funds come with specific conditions — such as funding a new program, supporting scholarships, or contributing to an endowment. These restrictions are legally binding, and failure to comply can result in donor dissatisfaction, legal action, or loss of organizational trust.

Contributions are considered restricted if they are given with conditions specifying how the money must be used or when it must be spent. These restrictions are outlined in the “gift instrument” — the formal document establishing the donor’s conditions. A gift instrument could be as formal as a foundation award letter or as simple as a handwritten note from a donor.

In financial reporting, restricted funds appear as “with donor restrictions.” They may be:

• Temporarily restricted: Released when a set period of time passes or a specific activity is completed.
• Permanently restricted: Intended to last forever, like contributions to an endowment where only interest or investment returns are used.

Importantly, when your organization receives notification of an irrevocable pledge, you must record the full amount in that fiscal year — even if payments arrive over several years. Often, this means revenue recognition happens in a different year than the related expenses, adding significant complexity to nonprofit accounting.

Nonprofits are not required to hold restricted funds in a separate bank account. However, they must account for them separately within their financial system and statements. Best practice dictates separating restricted and unrestricted funds during budgeting so money can be allocated properly.

Once a donor defines a restriction, the organization is legally obligated to honor it. If restricted funds are misused, donors may demand the return of funds — or even report the organization to the Office of the U.S. Attorney General, leading to fines or legal consequences.

1. Track Separately
Always distinguish restricted from unrestricted funds in your accounting system. Each gift should be coded by purpose or time period so you can generate clear reports for donors, auditors, and your board. Accurate tracking is the foundation of compliance and transparency.

2. Budget Strategically
Restricted dollars are not “extra” — they are committed to a specific purpose. Incorporating them directly into your annual budget ensures donor intent is honored and prevents accidental overspending from unrestricted funds. This creates a realistic financial plan that aligns with your programs.

3. Stay Compliant
Compliance requires continuous attention. Regularly review expenditures to confirm they align with donor restrictions, and maintain documentation for every restricted expense. A proactive compliance process protects your nonprofit from legal risks and builds long-term donor trust.

4. Create a Release From Restriction Account

• When donor conditions are met — a program milestone is achieved or a time period ends — funds should be “released” and reclassified as unrestricted revenue. A dedicated Release From Restriction account simplifies this process and ensures your financial statements remain accurate and audit-ready.

Managing restricted funds is complex — but it doesn’t have to be overwhelming. MissionGranted’s smart compliance tools make it easier to:

• Budget accurately: Automatically track restricted and unrestricted funds, keeping budgets aligned with donor requirements.
• Ensure compliance: Receive monthly alerts when expenses are unallowable, reducing the risk of audit issues.
• Streamline reporting: Correctly recognize multi-year grant revenue so financial statements remain accurate and transparent.

With MissionGranted, nonprofits gain confidence that restricted funds are compliant, efficient, and easy to manage — so you can focus on your mission, not your spreadsheets.

• Ready to simplify restricted fund management? Request a demo today.