Advisors doing better by doing good

Like everyone else, your retired clients can have conflicting financial goals. They might want to increase the income from their savings and other assets, but don’t want to take on too much investment risk. Or perhaps they’d like to support their favorite charities but they’re concerned that making large contributions will reduce their income and bequests to heirs. Planning with charitable income gifts can help clients accommodate these seemingly incompatible goals.

The basic premise behind the gifts is that a contributed asset’s principal can be valued separately from its income. It’s like valuing a bond: discount the interest payments and maturity principal at the appropriate interest rate, add them together and you have a market value for the bond.

How it Works

Charitable income gifts take the same approach. A donor irrevocably transfers an asset to a qualified charity or trust. In return, the charity agrees to pay an income to the donor (the income beneficiary). The starting date, frequency and duration of the income payments depend on the arrangement. When the payments end—at the donor’s death, for instance—the charity keeps the remaining funds as the remainder beneficiary. (Charitable lead trusts, which are not discussed in this article, reverse the transaction: The charity gets the income and the non-charitable beneficiary receives the remainder.)

From a tax perspective, the contribution consists of two parts: the income that will flow back to the donor and the remainder that stays with the charity. The remainder can qualify as an income tax deduction for the donor. Depending on the type of donated asset, the income payments will be taxed as a mix of ordinary income, long-term capital gain and a tax-free return of principal. Additionally, these strategies can often generate income streams higher than those available with other assets.

Here’s an example of a charitable gift annuity’s numbers using the online calculator from Planned Giving Design Center LLC.* The donors, a married couple both age 65, have a highly appreciated stock position. The shares have a low cost basis and are worth $100,000, but pay no dividend. The couple seeks additional income and also wants to benefit the college they attended. They donate the shares to the college in return for a joint-and-survivor lifetime annuity. The annuity will pay an annual rate of 4.2 percent ($4,200), with payments made monthly. Using the discount rates and mortality tables applicable in late September, the annuity has a present value of $73,965 and the remainder interest—the charitable deduction portion—is worth $26,035.

Multiple Options

The usual caveats about each case being client-specific apply, but this scenario illustrates the strategy’s potential benefits. Clients can generate more income from their assets and simultaneously receive a charitable deduction: the charity benefits from the contribution. For clients who fit the profile—both charitably inclined and those seeking more income—it’s a good deal. That doesn’t mean split-interest charitable gifts are a panacea, of course. The transactions are irrevocable, so the clients can’t change their minds and get their money back. Clients’ heirs might object, because the charity keeps the remainder when the income payments terminate.

Anne Ward, with Allodium Investment Consultants in Minneapolis, Minn., says these gifts typically appeal to clients who “tend to feel very secure in retirement.” They believe they’ve anticipated their personal and family financial needs and are comfortable making larger donations. In her experience, they are often philanthropic, looking at the greater good and the world beyond their inner circle. “But they don’t tend to get to that point until they feel like they have accumulated enough and that they’re going to be OK,” she says.

Donors can choose from an array of income-producing contribution strategies. The details on each are beyond the scope of this article, but the major types include charitable gift annuities (CGAs), charitable remainder annuity trusts (CRATs), charitable remainder unitrusts (CRUTs) and pooled income funds (PIFs). CRUTs are further classified as net income (NICRUTs), net income with makeup (NIMCRUTs) and flip unitrusts (FLIP-CRUTs).

Finding the Fit

There is no simple rule-of-thumb to identify which strategy will work best for a client. Each donor is unique and each strategy has its own set of rules, benefits and costs. Nonetheless, general guidelines can give donors some initial guidance as they consider the different strategies.

Contribution amount: It often doesn’t make sense to set up a trust if the gift is under $500,000, Ward notes, because the set up and operating costs can be high relative to the trust’s size. CGAs are usually more cost-efficient in those cases.

Contribution type: The type of asset being donated influences the strategy selection. Cash and liquid, marketable securities work with every strategy. CRUTs are better suited for illiquid assets, but you’ll need expert advice if your client wants to transfer non-financial assets to a trust.

Planned recipients: Using a CRUT is a more flexible approach for donors who aren’t sure which charity they want to receive the remainder or who want the option to change recipients. It’s also possible to designate a donor advised fund (DAF) as a charitable trust’s remainder beneficiary, Ward notes. Giving family members authority to recommend grant recipients from the DAF allows the donors to extend the family’s philanthropic work. “The donor advised fund is a charity,” she says. “It’s a qualified charity, but the money stays in an account from which it can be gifted. So after the client has passed away, it [allows them] to name their loved ones to take over the account and manage it and continue a legacy of gifting out of that trust.”

Desire for simplicity: CGAs make sense for donors who prefer a simpler operational format and are willing to give up control, says David Strege with Styverson Strege and Company in West Des Moines, Iowa. In contrast, CRUTs can work best for business owners or others who want control, are making sizable gifts and are accustomed to managing investments and complexity. “A charitable gift annuity is probably similar to somebody annuitizing an annuity,” he says. “It’s just going to give me an income stream. The insurance company is worrying about everything else.”

Organizational capacity:  It’s easy to overlook this factor, because we assume that every nonprofit welcomes every contribution. In reality, though, a small charity often won’t have the same gift-management resources as a larger nonprofit. If the expense and administrative hassle involved with accepting a split-interest gift is too large, the nonprofit might have to decline the offer.

These potential limitations have led Tracy Burke of Conrad Siegel Investment Advisors in Harrisburg, Pa. to work primarily with a community foundation in his area. The foundation has extensive expertise establishing and managing CRUTs, he says, and his firm recommends that clients seeking to make split-interest gifts consider working with the foundation. Similarly, colleges are “very well equipped for a charitable gift annuity approach” in Ward’s experience.

Wealth Replacement

As noted previously, donors’ heirs might not like the idea of split-interest gifts, because the contributions are irrevocable and a gift’s remainder stays with the charity. But some wealthy donors have no problem with the estate reduction that results from these gifts, in Strege’s experience. They believe their children will receive more than a sufficient inheritance and worry that leaving them too much money could be detrimental. In those cases, he says, the donors often have no interest in attempting to replace the donated wealth.

Other donors are concerned with estate depletion, however, and seek ways to replace part or all of the donated amount with wealth replacement strategies that can include life insurance. Mike Owens with Strategic Legacy Advisors in Omaha, Neb. cites an example of a client with a highly appreciated asset that’s generating very little or no income. Donating the asset in a split-interest gift immediately increases the donor’s cash flow. It’s also possible to increase the arrangement’s payout rate and further increase the incoming cash flow. Part of that income can then be used to purchase life insurance that will replace all or part of the gifted assets.

Owens often uses second-to-die coverage in wealth replacement cases because of its advantageous cost. The policies’ amounts vary with the clients’ goals. Some clients will replace the gifted amount, while others include the gift’s growth potential. In either case, though, Owens stresses the need to shop the preliminary application among insurers to find the best fit for desired product features and cost.

Planning Applications

Increased income and potential tax deductions are two key features for charitable income gifts, but the strategies also facilitate more advanced planning. Burke’s clients have created CRUTs in years when they do Roth IRA conversions to help offset the conversion’s tax impact. Owens has had clients approaching retirement gift non-dividend stocks to NIMCRUTs to capture the stocks’ growth while delaying trust distributions until the client retires. In a sense, he says, the trust can function as a kind of deferred compensation plan.

 

*The numerical illustration is copyright 2014, Planned Giving Design Center, LLC. www.pgdc.com. Used by permission.

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