Monday December 11, 2023
Article of the Month
Golden Age for Gift Annuities – Part II
However, in 1946 the fifteen million Americans who served in the military during World War II returned home and started families. As a result, the Baby Boomer generation (born 1946 to 1964) has nearly double the number of individuals turning age 75 each year when compared with the Quiet Generation. Because the senior Baby Boomers are now age 76, for the next two decades there will be a steady growth in the size of the primary gift annuity market. With a dramatic increase in potential annuitants, the coming decade is likely to be a golden age for gift annuities.
Testamentary Gift Annuities
A gift annuity is a contract between the charity and the donor. The donor transfers property to the charity and the charity promises to pay the annuity for one life or two lives. Sec. 514(c)(5).
As a contractual obligation, the annuity payments are secured by the assets of the charity. Most charities maintain an annuity reserve fund, which is required by some state insurance commissioners. However, the endowment and all of the real property and other assets of the charity stand behind the promise to pay a gift annuity. Most nonprofits who issue gift annuities have large reserves that assure the full payments will be made.
Many senior donors are delighted with their personal gift annuity and would like to leave part of their estate to fund gift annuity payments to a child, spouse, sibling, nephew or niece. If the donor is senior and passes away in his or her 90's, the beneficiary receiving the gift annuity payments may be age 70 or more. Fixed payments for this individual may be an excellent plan. This testamentary gift annuity may be funded with cash from the estate or a qualified retirement asset such as an IRA.
IRA to Testamentary Gift Annuity
IRAs and pension plans have grown dramatically in aggregate size during the past decade. Federal Reserve data suggests that there is more than $10 trillion in IRAs and over $25 trillion in cumulative qualified plans. These numbers will continue to grow in the future.
The cumulative balance in IRAs and other qualified plans will also increase during the next decade as a result of the new IRS mortality tables effective in 2022. Under the regulations, the minimum distributions are reduced. The minimum distribution rules under Sec. 1.401(a)(9)-5 use a distribution schedule that assumes that there is an IRA owner and a beneficiary 10 years younger. In addition to this assumption, the final regulations effective in 2022 use a mortality table with longer life expectancies.
As a result of the mortality table and the two-life expectancy calculation, the minimum distribution will usually be below the IRA growth rate until individuals are in their mid to late 80s. For example, if the IRA earns 6% per year, the balance will increase until age 84 under the minimum distribution table.
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A favorable rule within the regulations is that the designation of a charity or charitable trust will not affect the minimum distribution. Thus, it is possible to select a charity, a charitable trust or a charitable gift annuity as the designated beneficiary of an IRA. This designation will not affect the IRA required minimum withdrawals.
Testamentary Unitrust or Gift Annuity
One option that has been popular with many IRA owners is to transfer the IRA at death to a testamentary charitable remainder unitrust (CRUT). When the IRA owner passes away, the IRA designated beneficiary is the trustee of a CRUT. The CRUT may be a one-life trust for surviving spouse, a term of years trust for children or a multiple-life trust for two or more children or other heirs.
When a traditional IRA is transferred to the CRUT, the IRA is terminated. Fortunately, the charitable trust is tax exempt and no income tax is recognized at that time. The unitrust makes distribution of ordinary income to the spouse, children or other heirs. After all payments have been completed under the trust document, the remainder is distributed to charity.
However, there are several reasons why an IRA owner might instead prefer a testamentary gift annuity. First, if the beneficiary is fairly senior, the gift annuity will distribute a high fixed payout. Second, with the market fluctuations during the past several years, some beneficiaries would prefer to receive a fixed payout, rather than a payout that may change with market valuation. Third, the cost of administration for a gift annuity is usually much less than the trustee cost for a charitable remainder trust. Fourth, a gift annuity may be funded with a smaller amount, since it is easier and less expensive to administer. Many charitable organizations allow gift annuities to be funded with amounts as small as $10,000 or $20,000.
Testamentary CGA Private Letter Ruling
In PLR 200230018, the Service ruled favorably on an IRA owner's request to fund a testamentary charitable gift annuity. While a private letter ruling is not a precedent, it is a useful indication of the tax analysis of the Service with respect to any particular issue.
There were five specific favorable aspects to the ruling. These are:
- The charity's exemption is not affected.
- The charity does not have unrelated business income (UBTI) upon receipt of the IRA.
- The IRA is included in the IRA owner's estate.
- The estate will receive a partial estate tax deduction.
- The estate will not be taxed on the ordinary income from the IRA.
Exempt Status and UBTI
Charities and their charitable gift annuity reserve funds are exempt so long as they comply with several requirements. First, under Sec. 501(m)(1) the charity issuing a gift annuity must not be involved in commercial-type insurance. Second, under Sec. 514(c)(5)(A) the gift annuity must have a minimum charitable value of 10%, may be paid over only one or two lives, cannot require minimum or maximum payments and the payments may not be adjusted by reference to income earned by assets exchanged for the contract. If all of these requirements are followed, the charity's exempt status and the exempt status of the gift annuity reserve fund are not affected.
Gross Estate and Charitable Deduction
The IRA is includable in the estate as an asset of the IRA owner under Secs. 2031 and 2033. Thus, 100% of the value of the IRA upon date of death will be reported on the IRA owner's estate tax return.
However, Sec. 2055(e)(2)(a) permits a charitable deduction for the value that exceeds the present value of the annuity. By valuing the gift annuity under the rules set forth in Secs.72, 1011 and 7520, the excess of the IRA value over the annuity contract value will be permitted as a charitable estate tax deduction.
Income in Respect of a Decedent
When a traditional IRA is transferred to an estate or an individual, the IRA represents untaxed ordinary income or income in respect of a decedent (IRD). The individual or estate that receives the income will then be required to report the ordinary income.
If an estate satisfies a pecuniary bequest with an ordinary income asset, there is a recognition event and the estate is subject to tax on the ordinary income. Fortunately, the Service determined that the distribution of the IRA directly to the charity did not require recognition of gain by the estate. The charity is tax exempt and the IRA is IRD to the charity. However, consistent with distribution of other types of IRD, such as installment notes, the ordinary income will be recognized by the annuitant only as he or she receives the annuity payouts from the charity. In order to ensure that the income is taxable when received, PLR 200230018 notes that the annuity contract should not permit modification or commutation of annuity payouts. Since most traditional IRAs are 100% ordinary income, the high probability is that all gift annuity payments will be 100% ordinary income.
IRA to Gift Annuity for Spouse
If the gift annuity is created for the benefit of a surviving spouse, there will be both a charitable deduction for the excess value and a marital deduction under Sec. 2056(b)(7)(C) for the annuity contract value. If the surviving spouse is age 75 or older, it is possible that high fixed payouts and the fact that payments are secured by the assets of the issuing charity may make this option very attractive.
IRA to Gift Annuity for Single Brother or Sister
A testamentary gift annuity funded with an IRA may also be attractive for the donor who wishes to provide income for a single brother or sister and then benefit charity. In many families, there are single brothers or sisters who would benefit from fixed payments. Siblings frequently desire to provide assistance to those single persons. The testamentary gift annuity funded with an IRA is an excellent method for doing so. It again is particularly attractive if the single brother or sister is age 75 or older.
If the single brother or sister does not survive the IRA owner, then the assets will simply be distributed outright to charity. With the full distribution to charity, there will be a 100% estate tax deduction.
IRA to Gift Annuity for Child, Nephew or Niece
The IRA may be transferred to a testamentary charitable gift annuity for the IRA owner's child, nephew or niece. Since the child, nephew or niece is a generation younger, there are two available options. First, the testamentary gift annuity could be an immediate annuity, paying a lower rate. For example, if the child were age 55 to 60 when the parent passes away, the gift annuity rate would be under 5%.
Alternatively, a parent in this circumstance may choose to create a testamentary deferred payment gift annuity. This gift annuity could make payments, commencing at age 65 or 70, to the child, nephew or niece. This deferred payment gift annuity would have two advantages. First, there would be a higher payout at the time the beneficiary receives payments. Second, there would be a larger charitable estate tax deduction.
Designated Beneficiary Language
In PLR 200230018, the IRA owner created a gift annuity contract with the charity during his or her lifetime. This arrangement enabled the IRA owner to select the payout frequency, but the payout rate depends upon the standard rate paid by the charity based on the age of the beneficiary when the IRA owner dies and the value is transferred from the IRA account to the charity.
Another option for funding testamentary charitable gift annuities is to specify the annuity arrangement in the designated beneficiary statement and then allow the contract to be finalized after the IRA owner passes away.
For example, the designated beneficiary language could be as follows:
If Mary Jones of City, State shall survive me, then the Designated Beneficiary is Favorite Charity of City, State, for a nonassignable gift annuity payable quarterly for one life to Mary Jones, with payout at the standard rate Favorite Charity pays to annuitants of her age as of the date of my death. If Mary Jones of City, State shall not survive me, then the Designated Beneficiary is Favorite Charity of City, State.
This beneficiary language would allocate the IRA to the charitable gift annuity if Mary Jones survives the IRA owner. Since this is a testamentary provision, a stable and large charity with longevity in writing and administering gift annuities is preferred.
The gift annuity will be created and pay the standard rate as of date of the donor's death. The rate will also reflect Mary's age "rounded to the nearest half year" at that time. Since most charities follow the recommended rates of the American Council on Gift Annuities, it will probably be the ACGA rate for her age. Finally, in accordance with the language of PLR 200230018, the annuity contract should not permit modification or commutation of annuity payouts.
Notify the Charity About the Testamentary Gift Annuity
If the suggested language for an IRA to testamentary gift annuity is included in a beneficiary designation, it is suggested that the IRA owner send a copy of that IRA beneficiary designation to the charity. This notice should include the name and address of the IRA owner and the name, address, birth date and Social Security number of the future annuitant. Giving notice enables the charity to determine that the annuitant is qualified under its minimum age guidelines for the requested annuity. When the IRA owner passes away, the charity will then be prepared to issue the gift annuity for the selected recipient.
The IRA to testamentary charitable gift annuity plan is supported by one private letter ruling, which applies only to that IRA owner and is not a precedent. However, the key aspect of the ruling was that there will not be recognition of the IRD by either the estate or the charity. Given the clarity of the ruling on that point, many charities and IRA owners will choose to move forward with this attractive planning possibility.
With many Baby Boomers reaching their mid-70s in the coming decade, charitable gift annuities are entering a golden age. Donors will appreciate the fixed payments and generous fixed rates, combined with the ability to provide for family members and loved ones. Many donors will decide to fund a testamentary charitable gift annuity when presented with the benefits to family and charity.