Recent rising interest rates and longer life expectancies will shift the values between “income” and remaining interest in split interest trusts and charitable gift annuities, altering the tax incentives for these “planned” charitable giving vehicles “.
This article focuses specifically on the most widely used “planned” giving vehicle, the charitable gift annuity. And for illustrative purposes, we’ll use the typical case, an immediate gift annuity for a 79-year-old donor, funded by a $100k cash contribution. Simple vanilla, according to a recent survey by the American Council on Gift Annuities.
the generic case
As of January 1, 2023, the American Council on Gift Annuities’ recommended annuity payment for a 79-year-old beneficiary is 7.4%, sixty basis points higher than the recommended rate of 6.8%. implemented just six months earlier, and forty basis points higher than the 6.2 percent recommended payment that had been in place since July 1, 2020.
The ACGA’s recommended rates are calculated with reference to a rate of return assumption, which as of January 1 is 5.25 percent, a solid two points above the assumption in effect just a year ago. The rate of return assumption, less a 1.0 percent allowance for expenses, is intended to leave the issuing charity with a residual at the death of the annuity beneficiary of at least fifty percent of the initial financing contribution.
A higher 7520 rate will assign less value to a fixed annuity and more to the remainder after the beneficiary’s death. As of this writing in January 2023, the 7520 rate is 4.6 percent, slightly below the December high of 5.2 percent, but still three hundred basis points higher than the 1 rate, 6 percent from January 2022.
The comparison can be quite dramatic.
apples to apples
To compare apples to apples, suppose a 79-year-old pensioner would continue to accept the 6.2 percent annuity that he would have been offered a year ago, instead of the 7.4 percent that he might be offered now. And that she hasn’t aged in the past year. And we will take advantage of the two-month hindsight that the Tax Code allows in valuing gifts of remaining income or interest for charitable income tax deduction purposes.
The present value of an immediate annuity that pays 6.2% of a $100,000 contribution, in quarterly installments over the life of a 79-year-old annuitant, assuming a 7520 rate of 5.2%, is approximately $41,000, which which means the charitable income tax deduction for the present value of the residue to the issuing charity is approximately $59,000.
Whereas if we had made the same deal in January or February of last year, when the 7520 rate was still 1.6 percent, the present value of the annuity would have been about $50,100 and the deduction for the present value of the remainder would have been been around $49.9k. Therefore, we are looking at a spread of $9,100 just based on the interest rate assumption.
On the other hand, the recently published actuarial factors based on the increase in life expectancy reflected in the 2010 census data, once mandated, likely later this year, will have the effect of changing the value of the life interest.
In the particular example, use of the proposed tables would attribute a present value of about $43,800 to the annuity, assuming a 7520 rate of 5.2 percent, reducing the deduction for the present value of the remainder to $56,200. So this in itself could be an incentive to close the deal before the new tables become mandatory.
half the story
But the present value of the annuity flow versus the amount of the charitable income tax deduction is only part of the picture. Each annuity payment is treated for income tax purposes partly as ordinary income and partly as a return on investment in the contract. And these ratios also change based on the 7520 rate.
Again in the particular case, 33.1 cents for each dollar will be ordinary income and 66.9 cents will be return on investment, over the projected life expectancy of the pensioner of 9.9 years, that is, assuming a rate of 7520 of the 5.2 percent. If the 7520 rate was still 1.6 percent, these figures would be 18.4 cents and 81.6 cents.
In other words, while the higher 7520 rate produces a larger charitable income tax deduction, it also transfers a larger portion of each annuity payment to ordinary income.
In either case, if the beneficiary survives the “expected multiple of return,” the full annuity payment in the future will be ordinary income. Side note, if the annuity contract was financed with appreciated property, a portion of the portion of each payment treated as return on investment would be taxed as a capital gain for those 9.9 years.
This trade-off is often overlooked when the taxpayer is deciding which 7520 rate to apply when valuing their charitable income tax deduction. The Tax Code allows the taxpayer to apply the current rate for the month in which the operation actually takes place, or any of the two previous months.
As the example above illustrates, if the 7520 rate has moved significantly up or down during that interval, the election can have a large effect not only on the deduction but also on the income tax treatment of the annuity payment. .
