By: Rob Gordon, MBA, CFP®, AIFA®
A charitable gift annuity (CGA) offers donors the opportunity to convert non-income producing assets to a guaranteed lifetime income, reduce risk through diversification, receive immediate and potentially sizable tax deductions, and fulfill their charitable wishes.
Given future uncertainty regarding income tax rates, today might be a very good time to consider helping your favorite charity in this way.
How Does It Work?
In a charitable gift annuity there are, at a minimum, two parties: the charity (donee) and the donor (annuitant). The donor gives an asset to the charity in exchange for the promise of a regular payment back to the donor. In most cases, the donor is also permitted to name a joint annuitant such as a spouse to receive payments in case the donor dies. At the death of the last annuitant, the remainder passes to the organization. The diagram below shows the basic structure.
This strategy is ideal in situations where the donor has a non-income producing asset with a significant amount of embedded capital gains. A family farm or a large concentrated stock position are good examples. Donors avoid realizing the capital gains tax immediately and turn a non-income producing asset into an income producing asset. In addition, they get an immediate charitable tax deduction instead of an immediate tax bill!
Most CGAs are immediate payment annuities but deferred charitable gift annuities are gaining in popularity. Charitable gift annuities can be designed as a single-life annuity (payments made to one person for his/her lifetime); a joint annuity (payments made to two people simultaneously throughout the lifetime of the survivor); and a survivorship annuity (income paid throughout the lifetime of the annuitant and then continued payments to a beneficiary).
Let’s take a 70 year old individual who is considering a CGA as an option for increasing the income from his assets. He is considering donating his highly appreciated, undeveloped farm land to a local charity. The property is worth $1,000,000 of which $250,000 is long term capital gain. If he sold it today, he would owe Uncle Sam $37,500 in taxes on that transaction alone. As a charitably-minded individual, he is looking to create a legacy at his local charity. By signing a simple agreement, he is able to accomplish this with the property and simultaneously create an income stream for himself.
Annuity Rate 5.8%
Annual Payment $58,000
By donating the asset to the charity and then having them sell the asset, he avoids the immediate capital gains tax payment due in the year of sale. The charitable gift annuity is a split gift: there is an annuity which benefits the donor or annuitants he or she names and there is the charity which receives the amount that remains after the annuity has been paid out (referred to as the residuum). This donor’s immediate tax deduction is the present value of the residuum. The chart below summarizes the important figures generated by this transaction.
Present Value of the residuum (your tax deduction today) $346,110
Total Annual Annuity Income (paid to the annuitant) $58,000
Tax Free Portion of the Total Annuity Income $31,625
Taxable Capital Gain Portion of the Total Annuity Income $10,542
Taxable Ordinary Income Portion of the Total Annuity Income $15,833
These calculations were computed using the charitable gift calculator at http://campaign.virginia.edu, the University of Virginia’s planned giving website.
So, instead of a $37,500 tax bill, he would get an immediate charitable tax deduction of $360,939 (using an IRC Section 7520(a) discount rate of 2.4%). As you can see, he doesn’t escape paying taxes on the capital gains, he merely amortizes the payment over his life expectancy. Higher interest rates get you a higher immediate deduction but it also increases the taxable portion of each annuity payment. If the donor can’t use the entire deduction in one year, he can carry it over to future years subject to IRS rules.
Of course, every situation is unique. Consult competent specialists in this area to determine the effectiveness of this strategy for your needs.
The American Council on Gift Annuities (ACGA), publishes suggested rates of return for gift annuities annually. For more information on their methodology and rate tables, please visit www.acga-web.org. The stress is on the word “suggested”. Each charity that establishes a gift annuity program is free to set their own rates. Generally speaking, the annuity payout is designed to meet the payout commitment and leave 50% of the original contribution amount. Obviously, for the same sum of money, older donors have shorter life expectancies and therefore higher annuity payments than do younger donors.
A few final notes and caveats
The participation of charities in the Charitable Gift Annuities business is regulated on a state by state basis. New York, New Jersey and California are probably the strictest in terms of reserve, filing and other requirements.
If a charity failed to make promised payments on the annuity agreement, the donor would have a primary claim against the charity. For this reason, it is best to stick with Charitable Gift Annuities marketed by longstanding institutions though that isn’t the same as a true guarantee. Another option for the charity is to insure the annuity. This is a nice feature but it costs money, may lower your payment or reduce the residual amount or both. Due diligence is critical since the oversight is not uniform across the states.
With tax rates projected to rise steeply over the foreseeable future the time appears perfect for this charitable giving strategy.