Charitable Gift Annuities

Written by Hersh Stern Updated Saturday, October 5, 2024

Charitable gift giving is very much in the news these days. Many nonprofit organizations that had depended upon federal funding for a large part of their operating budgets are experiencing reductions from that source. Income tax levels are becoming increasingly punitive. People are looking for legitimate forms of tax relief. Additionally, more and more Americans are facing the probability that Social Security will be a completely inadequate "safety net" for their retirement. These concerned people are looking for tax-favored ways to augment their future retirement incomes.

Charitable gift annuities (CGAs) provide one solution to these concerns. A gift annuity offers immediate tax relief, and has the potential to provide some tax-free retirement income. In exchange for the gift contributions made to a charity, the charitable institution guarantees a retirement income, either immediate or deferred which can last for the entire lifetimes of the donor and spouse. In addition to the economic advantages, the donor can experience the satisfaction of seeing a part of the proceeds of a gift put to immediate use in a charitable institution which is dear to his or her heart.

How Do Charitable Gifts Work?

One popular method is the gifting of an irrevocably assigned life insurance policy to a charity. In that scenario, the donor deducts premiums as gifts, and upon the donor's death, the charity reaps a substantial benefit. Variations of charitable remainder trusts are another option for deferred giving. While the donor enjoys the benefit of lifetime income, the charity must wait for the donor's death before taking ownership and utilizing the gift remainder. A CGA, however, which is reinsured with an immediate annuity provides the charity with the advantage of immediate access to a significant portion of its gift proceeds.

Charitable Gift Annuities

A CGA is one of the easiest forms of planned giving. In exchange for an immediate gift to a legitimate 501(c)(3) charity, the donor is promised a specified lifetime income. The exact amount of that gift is agreed upon at inception. Typically, the life income goes to the donor or is shared as a 100 percent joint and survivor option to the donor and spouse. The arrangement is that simple. There is an agreement of understanding between the donor and the charity. The charity's stability and reputation provide peace of mind to the donor. If the charity ceased to make the agreed upon payments, the donor would be a primary creditor against that institution. Obviously, a century-old establishment such as a nonprofit hospital or major community church would have an easier time attracting a CGA donor than would a recently-established organization.

The maximum rates of return that are typically paid on these uninsured annuities are established by the American Council on Gift Annuities. The ACGA was established in 1927 as an answer to the "bidding wars" for donor dollars. Meeting each three years-the most current meeting in May 1995-this grouping of a large number of substantial national charitable organizations uses interest and mortality assumptions to set up current actuarial tables.

In a traditional situation where the donor dies around his or her actuarial life expectancy, the charity would have paid him a combination of interest and gift principal, which yielded a remainder of 50 percent. It is that substantial "expected remainder" which helps drive the IRS's acceptance of the CGA as a legitimate gift with well-defined tax advantages.

In the event a wealthy donor accepted a rate of return below the ACGA tables, it would pass on an even larger gift portion to the charity at the donor's death. In the event an organization offered rates of return considerably above the established tables, it runs the risk that the IRS may disallow the contribution as a gift.

How does Annuity Reinsurance Work?

Remember that the agreement is for the charity to pay a lifetime income to the donor. Once the agreement is completed, the manner in which the charity invests its assets to carry out that goal is exclusively the charity's business. The organization can take the full proceeds of the donor's gift to a bank's trust department and ask them to manage the assets in a portfolio.The bank, however, cannot guarantee that the principal will last for the lifetime of the donor. In the event that market conditions seriously diminish the value of a portfolio, those continued income payments may cease. Also, in the event that a donor significantly exceeds his or her life expectancy, all the resources of the gift may be exhausted.

If the gift proceeds are gone, the charity must reach into other resources to continue the lifetime payments. By utilizing annuity reinsurance, however, these risks can be completely eliminated.

In a reinsurance transaction, the charity takes the entire gift from the donor and in turn purchases a life annuity from an insurance company with the proceeds. The annuity can be immediate or deferred. The cost of purchasing that lifetime annuity is lower than the amount of the gift which was tendered.

In the case of immediate income annuities to donors in their seventies or older, the charity may be able to obtain the life annuities at a 35 to 50 percent discount. That spread between gift and purchased annuity represents outright cash which is available today to the charitable institution. The balance can be invested in an endowment fund, or used for other purposes.

When a donor is concerned about the guarantee of income that a charity is making, the annuity reinsurance is a valued dimension which helps the donor proceed with the gift. The charity is able to reassure the donor that a financially strong insurance company stands behind its commitment to guarantee him a lifelong income. The charity transfers to the insurance company all the interest rate risk, investment risk and mortality risk. The insurance company actuarially assumes all of these risks. In addition, the insurer takes on the administrative duties of monthly income payments and tax reporting.

What if the Donor is Very Old or In Poor Health?

In these situations, the charity may purchase a life annuity with a period certain guarantee. Such an annuity provides a life income regardless or the donor's lifespan plus it guarantees the income stream payments for a minimum fixed period, say ten years. If the charity is both the owner and the beneficiary of the annuity, it could benefit from any unused future guaranteed payments in the event the donor dies within the 10 year guarantee period.

So in a situation where a donor only survived two years of that 10 year period certain guarantee, the remaining eight years of payments would go directly to the charity as beneficiary of the policy. In this instance, the charity could ultimately obtain significantly more that its anticipated 50 percent remainder.

Gifting an appreciated asset

Many younger donors-professionals, entrepreneur, investors-may have a current asset which has appreciated considerably. Take the example of a doctor who purchased his clinic in the 1970's for $100,000 and at age 55 wishes to sell his building so that he can then go and work as a chief physician at a hospital for the next ten years before his retirement. The clinic's value has appreciated to $500,000. Selling it outright would trigger a $400,000 capital gain. If our doctor gifted this appreciated property to his hospital, the hospital could liquidate it at its current market value with the following results:

The doctor would receive a tax deduction based on its full appreciated current value-and the nonprofit institution would not have to deal with the capital gains tax. The doctor would then be guaranteed an income which not only reflects the current value of his gift, but also its compounded value over the next decade before that retirement income stream commences.

The taxes become a little more complex in this case. While the outright immediate deduction is still taken, there will be some recognition of capital gains because the gift was not completed outright-the doctor still reserved the right to future revenue. However, at retirement, he can pay his remaining capital gains taxes on an "installment plan" over his life expectancy. A part of each income payment would be taxed as either ordinary income or as capital gains. The capital gains may well be taxed at a lower tax rate than the ordinary income.

When the remaining capital gains have been paid off over the doctor's actuarial lifetime, a few good things happen: If the doctor is living, his guaranteed life income payments continue; and with the capital gains having been paid off, his annuity income stream will be taxed at a much lower rate.

Prospecting for Charitable Gift Annuities

Ask your clients if they have a charitable intent. Those who have already decided to gift to a favorite organization in the future may well want to consider the possible income and tax advantages of executing a gift today rather than upon death. The charitable intent is still first and foremost. There are other things that your clients can do with their money besides give it away. However, in the event that they wish to give a gift to a favorite charity and see their gift begin working during their lifetimes, a CGA may be their best option.

The simplest way to begin a CGA program in a charity is to contact their donor base of older clients who are in their retirement income years. These donors typically have many fixed investments such as CDs, T-bills, and the like. It may make sense for those donors to roll over some of those proceeds into a CGA. The CGA can also be structured to allow for the creation of a life insurance estate upon the death of the donor. If the donor is willing to accept a reduced income stream, part of the donation may be diverted to pay the premiums on a life insurance policy. This will generate a death benefit to relatives which could replace the capital gifted to the charity. Or the charity can be named as the beneficiary of the life insurance policy to receive the death benefit as a future gift.

Conclusion

A charitable gift annuity can provide to both a donor and a charity several important financial planning advantages. Donors can increase their income while obtaining significant tax reductions. Charities can tap into sources of funds which would not become available until the death of the donors. The CGA is a classic "win-win" situation to donor, charity, and agent alike.