Charitable Giving

Many people regularly contribute to charities and non-profit organizations. Some feel so strongly about their favorite organizations that they include them in their estate plans. In this way, loyal donors can make one last gift to the organizations and causes they really care about.

A life insurance policy may be an attractive way for clients to facilitate this final gift to their favorite charities. For clients who meet medical and financial underwriting requirements, there are at least three potential ways life insurance can enhance their charitable giving.

1. Replacing Assets Given Away During Life or At Death. When clients make large lifetime and/or testamentary gifts to their favorite charities, they will reduce what is left over for surviving family members to inherit. Life insurance may help clients “replace” all or part of these charitable gifts. A life insurance policy can let them be charitably inclined without reducing the financial legacy they pass on to surviving family members. Clients who want to make a final gift to charity through their estate plans often use one of these strategies:

A Bequest in a Will or Trust. A client may include specific written instructions to make charitable gifts in their will or revocable trust. These instructions are known as charitable bequests. The personal representative of the estate or the trustee of the trust follows the client’s wishes and makes the donation in the client’s name. Life insurance death benefits may help replace a charitable bequest and offset the lost inheritance.

Testamentary Gifts of Tax-Qualified Accounts. Many clients make charitable gifts at death through their tax-qualified accounts (e.g. pension plan balances, 401(k) accounts, and IRAs). Tax-qualified account balances are attractive as charitable gifts because family members who inherit them must pay income taxes on funds they withdraw from the account. Thus, the family members will only be able to spend the portion of the account left over after income taxes on the withdrawals have been paid. Depending on their marginal tax brackets and the application of state income taxes, a beneficiary could lose anywhere from 15% to 40% of the account balance to income taxes. Even worse, if the taxable estate is large enough, federal/state estate taxes on the account may also be triggered. This will reduce the after-tax account balance left for the family even more. When both estate and income taxes are due, as much as 70% to 80% of the account can be lost to taxes. This could leave as little as 20% to 30% for the family. However, if a charity is the account beneficiary, both income and estate taxes can be avoided. For this reason, tax qualified accounts can be attractive as charitable gifts at death.

A life insurance policy insuring the client's life can be used to “replace” the account’s value for the family. If the client doesn’t need to rely on the IRA income during retirement, he or she can take taxable withdrawals from the account to help pay the life insurance policy premiums.

Suppose Roger Wilson has a $800,000 IRA balance at his death and that his beneficiaries are each in a 25% combined federal and state income tax bracket. It would cost them $200,000 in income taxes to terminate the IRA and convert it into cash they could save, invest, or spend. These income taxes represent IRA funds that will be lost to the beneficiaries forever. On the other hand, if Roger names his alma mater as the IRA beneficiary, it can receive the entire $800,000 income and estate tax free. If he is insurable, Roger may be able to replace the $800,000 IRA balance for his family with an $800,000 life insurance policy. Taxable distributions from his IRA could help pay premiums. If he is over 59½, Roger can receive these distributions penalty-free. Roger should carefully consider how the policy is owned. If he has any incidents of ownership in it within the three years preceding his death, the policy proceeds may be subject to federal estate taxes.

Gifts in a Charitable Remainder Trust (CRT). Charitable remainder trusts are often used to make deferred gifts to charity. A client creates the CRT and transfers assets to it in return for a series of payments based on a percentage of the trust’s assets. This series of payments can last for a stated term of years, for the client’s lifetime, or for the lifetimes of both the client and his or her spouse.

Suppose Roger creates a charitable remainder annuity trust (CRAT) during his lifetime and funds it with $800,000 of property. He reserves an annual income from the trust of 5% of the trust’s initial value. At the time of his death, the value of the trust’s property is projected to be about $1 million. Roger names his alma mater as the trust’s remainder beneficiary and all the trust’s assets will pass to it at his death.

Assuming he is insurable, Roger can use the 5% annual payment from the CRAT to purchase a $1 million policy on his life and pay the annual premiums; his children can be the policy beneficiaries. The policy’s income-tax-free death benefits could replace the $1 million in assets the CRAT will pay to Roger’s alma mater at his death. If Roger has an estate tax problem, he may wish to create an irrevocable life insurance trust (ILIT) to own the policy. Another possibility is for the policy to be owned by Roger’s children. In either case, the premium payments Roger provides will be subject to gift tax (although they may qualify for the gift tax annual exclusion — $12,000 per donee in 2008).

2. Making a Charitable Gift At A “Discount.” Instead of transferring other assets to a favorite charity, clients can use life insurance death benefits to contribute money directly. This option can be simpler because the client doesn’t have to create a trust or change a beneficiary designation. The client simply arranges for the purchase of the policy and the charity is named as a beneficiary.

This strategy can be financially efficient for the client because a life insurance policy may allow him or her to make the charitable gift at less than its stated value. Because the premiums paid for the policy are usually less than the death benefit it pays out, a life insurance policy creates an opportunity to contribute to charity at a “discount.” The amount of the discount depends on the size of the death benefit, the health and life expectancy of the insured, and the number of premiums paid.

Suppose Roger wants to transfer exactly $400,000 to his alma mater at his death. Assume he is in good health and that he is able to purchase a $400,000 policy on his own life. He names his alma mater as the beneficiary. If the annual premium is $10,000, and Roger dies after 20 years, he will have paid a total of $200,000, but his alma mater will receive $400,000, a $200,000 discount.

3. “Leveraging” a Charitable Gift. A life insurance policy also can be used to create a larger gift. Because the death benefits the policy pays out exceed the premiums paid in, life insurance produces gifting “leverage” that can create a larger charitable legacy. The amount of leverage produced depends on many factors, including the size of the policy death benefit, the health and life expectancy of the insured, and the number of premiums paid.

For example, suppose Roger wants to transfer $400,000 to his alma mater at his death. Let’s assume Roger qualifies to purchase a $600,000 life insurance policy on himself for an annual premium of $20,000. If he dies after 20 years, Roger’s $400,000 in total premiums would produce a $600,000 death benefit for his alma mater, a $200,000 increase over the premiums he paid. The life insurance policy gives him the potential to leverage his gift into a significantly larger amount.

Alternatives For Owning The Life Insurance Policy

In using the “leveraging” and “discounting” strategies, there are two general ways to own the policy. The insured may either own it him or herself, or arrange for the charity to own it. If the charity owns the policy, it will name itself as the beneficiary. If the client buys the policy and then gives it to the charity, a charitable income tax deduction may be available for the policy’s fair market value. Additional cash gifts to the charity to help it pay future premiums may also qualify for income tax deductions.

A client who owns the policy him or herself will not be entitled to any income tax deductions. If income tax deductions aren’t needed, personal ownership of the policy often makes good sense. A client who retains ownership can change the amount of the death benefit (subject to underwriting limits), the amount of premiums paid, and the identity of the policy beneficiaries.

Clients who are uncertain which ownership approach is best can begin by owning the policy themselves. If the time comes when they no longer need the policy and won’t need to make further changes, they can transfer it then. An income tax deduction for the policy’s fair market value may be available when it is donated. When the client owns the policy, a charity can receive all or part of the death benefits as a policy beneficiary. The client can choose among several beneficiary designation options:

 •Sole beneficiary — the charity is the only beneficiary and receives all death benefits.
• Multiple beneficiaries — several individuals and/or charities are named to receive a specified percentage or a specific dollar amount of the total death benefit.
• Contingent beneficiary — the charity will receive the death benefit if the primary beneficiary dies before the insured or if the primary beneficiary disclaims all or part of the death benefit.
• Irrevocable beneficiary — once named, the beneficiary cannot be changed.

Conclusion

Life insurance can be a powerful tool to enhance charitable giving. It can help your clients do more for the charities they care about. Depending on the health and life expectancy of the insured, life insurance can potentially leverage premium payments into larger death benefits for the charity. It can also help replace assets clients transfer to charity during their lifetimes or at death. You may wish to advise clients who want to include charitable transfers in their estate plans to consider life insurance as part of their overall strategy.

The hypothetical examples in this article are for illustrative purposes only. They do not represent any specific product and should not be deemed a representation of actual results. Individual results will vary by individual and products selected. This article is not intended to be used to avoid tax penalties and was prepared to support the promotion or marketing of the matter addressed.