Less Is Often More – Tax Issues With Charitable Gift Annuities

Less is often more. With a charitable gift annuity, a donor accepting a lower charitable deduction may mean more for the donor in tax savings. That might seem counterintuitive, but a combination of an historically low discount rate and an increased standard deduction can have tax implications for a donor considering a gift annuity for your charity. For gift officers, the message is to illustrate all the tax options and let the donor and their advisor decide which alternative best suits their objectives.

The Charitable Gift Annuity – Part Gift, Part to Purchase an Annuity

When a donor makes a contribution for a charitable gift annuity, only part of the gift is tax deductible as a charitable contribution. Some of the contribution is to purchase an annuity – the right to receive lifetime income – and that portion is not tax deductible.

Andy and Betty – Maximizing Their Charitable Deduction

Part 1: The charitable gift vs. The cost of the annuity - Andy and Betty, age 75 and 72 respectively, make a gift of $50,000 cash to their favorite charity for a charitable gift annuity. They receive an annuity rate of 4.9% (the American Council on Gift Annuities rate in May 2020), with annual annuity payments of $2,450 ($50,000 x 4.9%). With a 1.8% discount rate (going back two months to March to get the higher discount rate), Andy and Betty maximize their charitable deduction by not taking the lower May discount rate of 0.8%. However, might there be a more tax-advantaged route, especially if Andy and Betty don’t itemize their deductions?

Part 2: Annuity payments - Tax-free vs. Ordinary income. Andy and Betty’s annual annuity payments will be $2,450. Some of that payment will be taxed as ordinary income, and some as tax-free. Why tax-free? The amount used to purchase the annuity ($33,550.50) is returned to the donor/annuitants over their actuarial lifetime. The IRS does not impose income tax when you get your own funds back. If you lend someone money and they pay the loan back with interest, you pay tax on the interest but not the principal. The principal was your money to begin with. This concept applies to gift annuity payments. How does this mathematically impact Andy and Betty? For their ages of 75 and 72, their actuarial lifetime is 17.7 years. For 17.7 years, $1,895.51 of their annual annuity payments will be tax-free ($33,550.50 ÷ 17.7 = $1,895.51). The remaining part of their annual annuity payments ($554.49) will be taxed as ordinary income. After 17.7 years there will be no tax-free income to distribute and the entire annuity payment will be taxed as ordinary income.

What if Andy and Betty Take the Standard Deduction?

Since the standard deduction was essentially doubled starting in 2018, only about 10% of taxpayers itemize their deductions. In 2020, the standard deduction for a married couple filing jointly will be $24,800 (for a single taxpayer the standard deduction will be $12,400), plus additional amounts for taxpayers 65 & older. For Andy and Betty who may no longer itemize, what would be the result of their taking a lower charitable deduction?

Andy and Betty – Minimizing Their Charitable Deduction (Maximizing Tax-Free Income)

What would be the tax implications for Andy and Betty if they select the historically low May 2020 discount rate of 0.8%, thereby minimizing their charitable deduction? The lower discount rate assumes the gift assets will only earn 0.8% annually over the gift term, leaving less for charity. If there is less for charity, the charitable deduction is less and the portion to purchase the annuity will be more.

The cost of the annuity contract with an 0.8% discount rate is $36,622.50, whereas the cost of the annuity contract with a 1.8% discount rate is $33,550.50. The difference between the two is $3,072 ($36,622.50 - $33,550.50 = $3,072), which amount will be returned to Andy and Betty as additional tax-free income in the annuity payments. If Andy and Betty are using the standard deduction, the lower discount rate resulting in a lower charitable deduction should not adversely affect them from a tax perspective.

What if Andy and Betty Use Appreciated Assets to Fund the Gift Annuity?

If Andy and Betty use appreciated assets qualifying for long-term capital gain tax treatment to fund the gift annuity, the capital gain will be apportioned between the charitable portion of the annuity and the non-charitable portion used to purchase the annuity contract. The gain apportioned to the charitable gift is completely forgiven. However, the gain apportioned to the purchase of the annuity contract will be taxed over the donor/annuitants’ actuarial lifetime. The net effect is there is now a capital gain tax tier in the annuity payments. There will be less tax-free income in the payments. 

Show Donors Their Options

There is often an inclination to maximize the charitable deduction when preparing a gift illustration for a donor, choosing the highest discount rate permissible for a CGA. However, for a donor taking the standard deduction that may not be the best course of action. Admittedly, if the charitable deduction exceeds the standard deduction, it increases the likelihood that the donor will itemize. However, donors and their advisors should make this decision. It is good practice for the gift officer to present options to the donor, point out the differences, and then defer to the donor and their advisor. Some charities have a space on their gift annuity application form for the donor to designate which (highest or lowest) discount rate they wish to use. Donors need complete information to make informed decisions, which requires that they have all the options for the gift under consideration.