Charitable Gift Annuity Planning Opportunities Under Rising Interest Rates

Recent rising interest rates and longer table life expectancies will shift values as between “income” and remainder interests in split interest trusts and charitable gift annuities, altering the tax incentives for these “planned” charitable gift vehicles.

This article focuses specifically on the most commonly used “planned” giving vehicle, the charitable gift annuity. And for purposes of illustration, we will use the typical case, an immediate gift annuity for a donor aged 79 years, funded with a cash contribution of $100k. Plain vanilla, according to a recent survey by the American Council on Gift Annuities.

The Generic Case

Effective January 1, 2023, the annuity payout recommended by the American Council on Gift Annuities for an annuitant aged 79 years is 7.4 percent, up sixty basis points from the 6.8 percent recommended rate implemented only six months previously, and up forty basis points from the 6.2 percent recommended payout that had been in place since July 01, 2020.

The ACGA recommended rates are calculated with reference to a rate of return assumption, which as of January 01 is 5.25 percent, up two solid points from the assumption that was in force only a year ago. The rate of return assumption, minus an allowance of 1.0 percent for expenses, is intended to leave the issuing charity with a residuum at the annuitant’s death of at least fifty percent of the initial funding contribution.

A higher 7520 rate will ascribe less value to a fixed annuity and more to the remainder after the annuitant’s death. At this writing in January 2023, the 7520 rate is 4.6 percent, down somewhat from a peak at 5.2 percent in December, but still up three hundred basis points from the January 2022 rate of 1.6 percent.

The comparison can be quite dramatic.

Apples to Apples

To compare apples to apples, we will suppose a 79 year old annuitant would still accept the 6.2 percent annuity she would have been offered a year ago, rather than the 7.4 percent she might be offered now. And that she has not aged in the intervening year. And we will take advantage of the two-month lookback the tax Code allows in valuing gifts of income or remainder interests for purposes of the income tax charitable deduction.

The present value of an immediate annuity paying 6.2 percent of a $100k contribution, in quarterly installments over the life of an annuitant aged 79 years, assuming a 7520 rate of 5.2 percent, is about $41.0k, which means the income tax charitable deduction for the present value of the residuum to the issuing charity is about $59.0k.

Whereas if we had done the same deal back in January or February last year, when the 7520 rate was still 1.6 percent, the present value of the annuity would have been about $50.1k and the deduction for the present value of the residuum would have been about $49.9k. So we are looking at a $9.1k spread just based on the interest rate assumption.

On the other hand, the recently published actuarial factors based on increased life expectancies reflected in the 2010 census data, once they become mandatory, probably later this year, will have the effect of shifting value to the life interest.

In the particular example, using the proposed tables would ascribe a present value of about $43.8k to the annuity, assuming a 7520 rate of 5.2 percent, reducing the deduction for the present value of the residuum to $56.2k. So this in itself might be an incentive to close the deal before the new tables become mandatory.

Half the Story

But the present value of the annuity stream versus the amount of the income tax charitable deduction is only a part of the picture. Each annuity payment is treated for income tax purposes as in part ordinary income and in part a return of the investment in the contract. And these proportions also shift depending on the 7520 rate.

Again in the particular case, 33.1 cents on every dollar will be ordinary income and 66.9 cents will be return of investment, over the annuitant’s projected life expectancy of 9.9 years — that is, assuming a 7520 rate of 5.2 percent. If the 7520 rate were still 1.6 percent, these figures would be 18.4 cents and 81.6 cents.

In other words, while the higher 7520 rate yields a larger income tax charitable deduction, it also shifts a larger portion of each annuity payment into ordinary income.

In either case, if the annuitant survives the “expected return multiple,” the entire annuity payout going forward will be ordinary income. Footnote, if the annuity contract were funded with appreciated property, some part of the portion of each payment treated as a return of investment would be taxed as capital gain over those 9.9 years.

This tradeoff is often overlooked when the taxpayer is deciding which 7520 rate to apply in valuing her income tax charitable deduction. The tax Code allows the taxpayer to apply the rate in effect for the month in which the transaction actually occurs, or either of the preceding two months.

As the foregoing example illustrates, if the 7520 rate has moved significantly up or down over that interval, the election can have a large effect not only on the deduction but also on the income tax treatment of the annuity payout.

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