What if you would like to benefit charity, but because you need the income stream they provide you aren’t comfortable parting with your assets? Two charitable techniques are available that may meet your needs. One is a charitable gift annuity (CGA). The second is a charitable remainder trust (CRT). This post discusses Charitable gift annuities; check back next month for my post on charitable remainder trusts.
Charitable Gift Annuities Described
A charitable gift annuity (CGA) is similar to a commercial annuity, but you contract with a charity instead of an insurance company for the annuity payment. The terms of the annuity contract require the charity to pay to you (or you and one other person, such as your spouse) a fixed sum of money over either your lifetime or the joint lifetimes of you and one other person (such as your spouse).
The amount payable under the contract depends on how much you pay for the contract, the interest rate used to calculate the annuity payments due, and the expected length over which the payments will be made. The length of time over which the payments are expected to be made depends upon the annuitant’s (or annuitants’) life expectancy(ies). The interest rate used to calculate the payment depends upon the age (or ages) of the annuitant(s).
Calculating the Annuity Payment
In calculating the annuity payable, most charities use an interest rate supplied by the American Council on Gift Annuities (and most states regulate a charity’s issuance of CGAs). Charitable gift annuities pay less than commercial annuities, and are usually designed so that it is probable charity will receive fifty percent of the amount paid for the contract when the annuity payments cease. However, the amount charity actually ends up with after the annuity payments cease depends upon the investment returns generated by the charity.
Calculating the Income Tax Deduction
In addition to the payments you receive from the CGA, there are potential income tax benefits from the purchase of a CGA. At the time you purchase the annuity contract, you are entitled to a charitable income tax deduction. The income tax deduction you can claim on your tax return equals the amount paid for the CGA minus the actuarially calculated value of the payments expected to be made under the contract. The value of the expected contract payments is calculated using an interest rate and calculation method provided by the Internal Revenue Service.
You receive an income tax benefit from the purchase of a CGA only if you itemize deductions on your tax return. If, instead, you claim the standard deduction in the year you purchase a CGA, you won’t receive any income tax benefits as a result of purchasing the contract.
Charitable Gift Annuity Example
If, today, you purchase a joint CGA for $100,000 (paid in cash), payable over the lifetimes of you and your spouse, and you are 75 and your spouse is 70, with payments made to you on an annual basis, you and your spouse would receive an annual payment $5,200 until the second death (this assumes the charity you purchase the annuity from uses the interest rate supplied by the American Council on Gift Annuities of 5.2% applicable to this fact pattern). You would also generate a $30,539 charitable income tax deduction that you can claim on your tax return this year.
Income Tax Impact of Annuity Payments
As in the case of payments from a commercial annuity, annuity payments made to you when you enter into a CGA are subject to income tax. Only a portion of the annuity payment is subject to tax. The exclusion ratio depends upon the expected return to the annuitant over their lifetime. The expected return is calculated using rules supplied by the IRS. Using the above example, the calculated exclusion ratio is 69.2%. As a result, 69.2% ($3,598) of each annual payment you receive is excluded from income tax. The remaining 30.8% of each annual payment to you ($1,602) is subject to income tax each year. Because you paid cash for the CGA, the annuity payment subject to tax is subject to ordinary income tax rates.
Don’t worry. You or your tax preparer won’t have to calculate the taxable portion of the CGA payments you receive each year. The charity you purchase the CGA from will send you an annual 1099 with that information.
Using Long-term Capital Gain Property to Purchase the CGA
You can enhance the tax benefits of charitable gift annuities by purchasing the CGA with appreciated, long-term capital gain property such as publicly traded stock.
Normally, if you sell appreciated stock, you must pay all taxes associated with the sale when you file your income tax return for the year during which the sale occurred. If, instead, you use the same stock to purchase a CGA, payment of capital gains taxes is deferred.
Transfer of an asset to purchase a CGA is considered a “bargain sale,” and you pay capital gains taxes only as you received payments under the CGA contract. This enhances the benefit of the CGA since you defer payment of capital gain taxes over your lifetime.
Income Tax Impact of Annuity Payments – CGA Purchased With Property
Revisiting the previous example, if instead of transferring $100,000 of cash to a charity to purchase the CGA, you transfer stock worth $100,000 that you purchased for $30,000 ten years ago (so it is long-term capital gain property), the $2,946 of each annual payment to you is taxed at capital gains tax rates, $1,602 is taxed at your ordinary income tax rate, and the remaining $652 of each $5,200 annual payment is tax free return of capital.
If you had sold the $100,000 stock rather than transferring to a charity in exchange for a CGA contract, you would pay all taxes on the entire capital gain of $70,000 in the year of the sale.
In the above examples, I assumed the annuity payment under the CGA contract would be made on an annual basis. A CGA contact can be structured to provide payments on monthly, quarterly, or annual basis.
My examples also assumed that the annuity payment would start in the same year you purchase a CGA contract. Deferred CGA contracts are also available, just like you can purchase a deferred commercial annuity contract. Under a deferred CGA contract, annuity payments to you wouldn’t start until a future date.
The advantage to a deferred contact is that payments made to you when they do start will be higher than those made under an immediate contract.
Finally, not all charities offer charitable gift annuities (DonorsTrust does not). Indeed, if you are interest in the idea of a CGA, your most difficult task may be finding a charity that you want to support offering a CGA program.
My next post will discuss charitable remainder trusts. Charitable remainder trusts offer benefits similar to charitable gift annuities.