A mainstay of tax and retirement planning from years gone by is making a comeback, and it deserves to be considered in your plans.
As the baby boomers age and market volatility increases, more Americans are seeking secure lifetime income. There’s a way to obtain guaranteed lifetime income and net a substantial tax deduction in the process.
You don’t even need cash to execute this strategy. You can use appreciated stock or other investments (at no tax cost to you). You also can use the equity in your home, without having to sell or move out of the home.
The strategy is the charitable gift annuity (CGA). The CGA is simple. You transfer money or property to a charity. The charity agrees to pay you a fixed amount of income. The income can last for your life, the joint life of you and your spouse, or a fixed period of years. You determine how long the income will be paid. The longer the period you select, the lower each income payment will be but the more secure you’ll be.
Usually, you decide whether the income is paid monthly, quarterly, or annually. You also receive a charitable contribution deduction when you create the CGA.
The income the charity pays will be less than what you’d receive from a commercial annuity. The difference is a gift from you to the charity. You’re allowed to deduct the present value of that gift in the year you transfer property to the charity for the annuity.
The amount of the deduction is determined using tables issued by the IRS. The deduction will vary based on current interest rates and your age (or the time over which the annuity payments will be made). The older you are, the higher the tax deduction will be. But the lower interest rates are, the lower the deduction will be. Most donors deduct 25% to 55% of the amount they put into the annuity.
You also must itemize expenses on your tax return to receive a tax advantage from the contribution. You itemize expenses only if your itemized expense deductions exceed the standard deduction. Since the standard deduction was doubled in the 2017 tax law (it’s more than $24,000 for married couple filing jointly in 2019), a minority of taxpayers now itemize expenses.
Because the charitable gift from setting up the CGA is expected to be significant, you’re likely to itemize expenses in the year the CGA is set up. You can maximize the tax benefits by bunching any other itemized expenses in that year.
For example, you might maximize medical expenses by having elective medical procedures done in that year. There’s another tax benefit to the CGA. When income payments are received under the CGA, part of each payment will be tax free as a return of your principal.
Once the terms of the annuity are set, you use IRS Publication 939 to compute the exclusion ratio. This is the amount of each annuity payment that is excluded from your gross income, and it depends on your investment in the annuity, how long the annuity payments are expected to last, and the amount of each annuity payment. With interest rates low, you’re going to exclude a high percentage of each payment from income. Most retirees or near retirees who set up CGAs now are going to exclude from income more than half, often much more than half, of each annuity payment.
There also is a flip side. Suppose the annuity payments are guaranteed for your life. When you live beyond life expectancy, you’ll have been paid your principal. After that, each annuity payment will be fully taxable.
You’ll have won the annuity lottery by living past the average life expectancy for your birth year, and the charity will be paying your future income from money earned on the contributions from you and others. But the annuity payments will be fully taxable. You will need to factor that taxable income in your tax planning.
All these tax benefits assume that the money or property you transfer to set up the CGA are from a taxable account, not an IRA or other qualified retirement account. You can fund the CGA with cash, but there are better funding strategies for many people.
Most charities accept many different types of property as contributions. When you donate appreciated investment property, you don’t owe capital gains taxes on the appreciation. For tax deduction purposes and for purposes of determining the amount you used to fund the annuity, the fair market value of the property on the date of the contribution is used. Neither you nor the charity pays capital gains taxes on the appreciation.
With most other strategies, the real value of appreciated assets to you is the after-tax value. But with the CGA, you benefit from the full fair market value.
You can contribute appreciated mutual fund shares, stocks, bonds and investment real estate. You also might be able to contribute art, collectibles and other property. Ask the charities of your choice the types of assets they’ll accept.
You might not even have to give up property or cash to set up a CGA. Suppose you have equity in your home and don’t plan to sell or move out of your home. You can transfer a remainder interest in the home to a charity, known as a charitable remainder.
You set up a remainder interest in favor of the charity by changing the deed and filing it in the public property records. Under a remainder interest, you stay in the home the rest of your life and treat it the same as always. You are the owner. But after you pass away, the charity becomes owner of the home. It likely will sell the home and put the sale proceeds in its endowment.
In the meantime, after you set up the charitable remainder interest, the charity begins making the CGA payments to you. You’ve converted an asset you weren’t using, the home equity, into a stream of income for the rest of your life. There will be little or no effect on your lifestyle, and you’ll benefit from today’s relatively high home prices.
If you choose or need to sell the home during your life, the charity will have the right to part of the sale proceeds. If you live on a farm, ranch, or similar property, you can give the charity a remainder interest in the residence portion of the property and leave the working portion to be inherited by your heirs.
A CGA doesn’t have to be set up during your lifetime.
Suppose you want to provide for a loved one but are concerned the person won’t handle a large inheritance well. You can set up a CGA in your will. Designate the property to be transferred to charity and the beneficiary under the CGA. The individual beneficiary will receive regular income for life. A CGA also can be a deferred annuity.
You transfer money or property to the charity today and qualify for the tax deduction. But the income payments don’t begin until a date in the future you selected. Credit risk is the biggest risk of a CGA. There’s nothing backing the annuity other than the charity’s promise to pay.
If the charity suffers financial hard times, you have no rights other than those of a general creditor. There is no separate account or property in your name or securing the annuity. You need to investigate a charity’s financial status carefully before engaging in a CGA with it.
Most charities use the payout rates recommended by the American Council on Gift Annuities. You can see its rate tables at www.acga-web.org. (The hyphen is part of the address.)
A married couple, both age 65 today, choosing a joint life annuity will receive a payout of 4.5% of the amount contributed. Remember the payout will be less than for a commercial annuity, because you’re making a gift to the charity.