Tuesday January 19, 2021
Article of the Month
A Case for Charitable Gift Annuities Part II
A strong CGA program will benefit charities and donors alike. Charities can enhance donor relations and stewardship opportunities by offering CGAs. The first article in this series covered the basics of CGAs and some threshold requirements to begin a CGA program. This article will discuss the benefits of a CGA program for donors and charities.
Benefits for Donors
Easy to Establish
A gift annuity agreement is a relatively simple contract between the charity and the donor. Most charities have form contracts approved by their counsel that comply with state regulations. Because the charity has a form contract, the donor does not need to hire an attorney to draft the CGA contract. It may be wise for a donor to have his or her attorney review the contract prior to entering into the agreement.
Charitable Deduction and Fixed Income
A gift annuity is a bargain sale, with two component parts – part gift to the charity and part income stream for the annuitant. In exchange for the gift from the donor in the form of the CGA contract with the charity, the donor will receive a tax deduction. Additionally, the charity will issue fixed payments for one life or the lives of the annuitants. These payments may be a way for the donor to provide a fixed payout stream for a spouse or other family members.
Certificates of Deposit
Some individuals may have their assets tied up in certificates of deposit (CDs). Typical CD offerings hover at approximately 2% interest. Taxes are paid by the holder each year on the gain earned by the investment. The money invested in a CD becomes available after a set time period selected by the owner and will be available as cash. If the owner wants to continue investing the cash, the funds must be rolled over into another CD or an investment of the owner’s choosing. A CGA is a charitable alternative to creating a new CD. It will benefit the donor during his or her lifetime and also benefit charity. It is important to note that once the funds are used to create a CGA, the donor is unable to retrieve the funds, unlike the funds in a CD.
The CGA payout is based on the age of the annuitant at the time the annuity begins; an older annuitant will receive a larger payout percentage. The payout coming from a charitable gift annuity will often be higher than other conservative investments such as CDs. The donor will have made an irrevocable gift in setting up the charitable gift annuity. A charitably-minded donor will enjoy the fixed payouts from the CGA and the knowledge that a legacy gift will also be provided to the charity. Generally, the payout percentage from a gift annuity will be greater than the income earned on the CD. A good option for a donor may be to use a portion of a CD portfolio after the CD matures to establish a gift annuity. This would permit the donor to retain some liquid assets, while also creating a charitable income tax deduction.
ExampleA wonderful feature of a gift annuity is that beside the fixed payout, the agreement provides the donor with additional benefits in the form of a charitable deduction and partially tax-free payouts. With a CD or other investment, the donor would not receive an income tax deduction or partly tax-free income each year. The double tax savings – income tax savings from the charitable deduction in the year of the gift and the additional tax savings from the tax-favored CGA payments – are likened to receiving a higher rate of return. Due to the fact that these payout rates are not interest rates, but rather payouts that will diminish the gift principal, this is an inexact comparison. However, if the donor desires to benefit charity and secure a fixed payout stream, a CGA is a great option to discuss with a trusted financial advisor.
John is a loyal donor at his favorite local charity. He is a conservative investor and has $100,000 invested in CDs. He receives 2% income from these investments. John takes $35,000 of cash that was formerly in a CD, and instead of reinvesting in another CD, he establishes a charitable gift annuity. John has made an irrevocable gift to charity. Unlike investing in CDs, the funding value of the CGA will not return to him in a lump sum at an appointed time. He continues to invest $65,000 in CDs. The CDs produce 2% interest income per year, generating about $1,300. John’s $35,000 gift annuity pays out at a rate of 7.4%, generating a payout stream of $2,590 per year for the remainder of his life. Additionally, John will receive a $16,658 tax deduction. His income tax rate is 24%, so his estimated tax savings in the year of the gift are $3,997. Compared to the return rate for a CD, the “effective rate” of a gift annuity is actually higher than the 7.4% payout rate. The gift annuity payout for John is $2,590 per year. However, when one considers the benefits of John’s tax savings, it is similar to receiving $3,997 or an 11.4% payout in the first year from other taxable investments.
Many donors also have appreciated assets such as stock. If a potential donor sells an appreciated asset, the proceeds will likely be subject to capital gains taxes from the sale. However, if a donor were to transfer that same stock to charity outright, the donor would receive an income tax deduction for the entire amount of the gift. In addition, the charity would not have to pay capital gains tax when it sells the asset. Therefore, the full value of the donor’s asset may be put to use by charity.
Similarly, a donor may use appreciated assets to fund a gift annuity. The portion of the charitable gift annuity that is the gift to charity will avoid a proportionate share of capital gains tax. The donor will receive a tax deduction for the present value of the gift. The remaining capital gains will be spread out over the donor’s life expectancy through the payouts. This allows the donor to recognize a smaller amount of capital gains each year.
If the annuity is being paid to someone other than the donor, this favorable treatment is not received. If appreciated property is used to fund a CGA for a person other than the donor, the capital gains associated with the annuity portion of the gift will be taxable to the donor in the year of the gift.
Tax Implications of Charitable Deductions
Following the passage of the Tax Cuts and Jobs Act of 2017 (TCJA), the standard deduction was nearly doubled from $6,500 to $12,000 for individual filers and $13,000 to $24,000 for married filing jointly, indexed for inflation. In 2020, the standard deduction is $12,400 for individuals and $24,800 for married filing jointly. Due to this increase in the standard deduction, many taxpayers became non-itemizers. This is a crucial fact because charitable income tax deduction benefits are realized only as itemized income tax deductions.
One way for donors to continue to give to charity and take itemized deductions is by “bunching gifts” one year and putting a hold on charitable giving the next year. By giving an amount greater than the standard deduction amount in year one, donors will be able to take a charitable deduction through itemizing on their tax returns. Through itemizing, donors will realize tax savings. In the following year, the donors may use the standard deduction and choose not to make a charitable gift. This allows the donor to save more from itemizing their charitable income tax deduction in year one than if they had they donated the same total amount but divided it equally between the years and claimed the standard deduction each year.
ExampleThis “bunching” concept applies to establishing gift annuities as well. Donors could potentially increase their giving in one year to establish a CGA. The donor would receive a deduction in Year 1 based on itemizing deductions, and in Year 2 could simply take the standard deduction. Meanwhile, the donor will also have helped a charity and created a fixed payout stream for life.
Let us look at two couples, John and Mary Jones and Harry and Susan Green. Both pay $8,000 in state and local taxes and $7,000 in home mortgage interest. They each give $8,000 to their favorite charity each year. The total itemized deductions for each couple are $23,000 per year.
Because the standard deduction is larger than their $23,000 in itemized deductions, John and Mary claim the $24,400 standard deduction in 2019 and the $24,800 amount in 2020. Their total deductions over the two years are $49,200.
Meanwhile, Harry and Susan decide to “bunch” their charitable deductions. They give $16,000 in 2019 and nothing in 2020. Because their total 2019 itemized deductions with the increased charitable deduction now reaches $31,000, the standard deduction is exceeded. Harry and Susan elect to itemize their 2019 tax deductions. In 2020, they take the standard deduction of $24,800. Their total claimed deductions are $55,800.
By “bunching” their deductions, Harry and Susan increase their tax savings from their charitable gifts. The $6,600 increased deductions may save $1,848 in their 28% combined federal and state income tax brackets.
Joseph and Judy, age 83, are both retired. They typically make generous gifts to charity of $18,000 each year and include it with their income tax deductions. The couple would like an income tax deduction this year and would also like to supplement their annual income, but since the TCJA doubled the standard deduction, their $18,000 gift, along with their other deductible expenses, does not exceed the standard deduction. They ask their tax advisor if there is any way they can take a deduction this year while also increasing their annual income. The couple’s advisor explains that they may wish to “bunch” their charitable gifts. He also notes that Joseph and Judy may wish to look into a charitable gift annuity. With a $45,000 funding amount, the couple will get a deduction of $20,295 this year. This deduction may save $4,870 in income tax. They will itemize their charitable deduction along with their other deductible expenses. At the current 2020 ACGA suggested maximum rate of 6.4%, Joseph and Judy will receive a $2,880 payout each year for their lifetimes.
Benefits for Charity
Growth of Principal
Charities will invest the donor’s CGA contribution. The charitable organization will make payments to the donor over time according to the payment frequency, meanwhile the amount of the principal contribution will generally grow based upon investments. According to the ACGA, if a charity follows the AGCA recommended investment strategy, the charity can expect to receive approximately 50% of the initial amount of funding for all its charitable gift annuities on average. The ACGA conducts periodic surveys for data on CGA contracts. In each survey conducted since 2004, the average residuum reported was higher than the 50% targeted amount. This residuum is expressed as a nominal value rather than a present value. The ACGA rates reflect the policy that the present value of the residuum must be at least 20% of the original gift amount.
The ACGA rates assume an investment portfolio consisting of 40% stocks, 55% in Treasury bonds and 5% in cash and cash equivalents. In some states, this particular allocation of investments may not be possible, based on state regulations (see: A Case for CGAs, “State Law Considerations”). The ACGA recommends charities work with their investment advisors to select the asset allocation appropriate for each particular set of facts and circumstances.
In addition to growth over time based on investments, charities may also see repeat donors with multiple annuities. Many donors enjoy gift annuities so much that they establish multiple CGAs over their lifetimes. The continued relationship between the donor and the charity often means that the charity has numerous stewardship opportunities. In turn, a donor may be more likely to remember the charity in his or her long-term giving plans.
Donors may be considered part of a legacy society by the charity where their CGA was established. They may be invited to special events and honored at functions. Based on these continued contacts, a donor may be interested in subscribing to the charity’s newsletter to keep in touch and read about helpful information such as tips for saving in retirement, estate planning and senior living. These continued interactions may be beneficial for all involved and create a vibrant community.
Charitable gift annuities will provide donors with a charitable deduction and a fixed stream of payouts, along with a way to support causes dear to them. Charities, on average, are likely to realize at least half of the initial amount used to fund a CGA and may see additional gifts in the future because of their CGA program. Charities and donors are likely to benefit from the enhanced relationships and opportunity for community that a CGA program may provide.