For clients interested in making charitable bequests, it is important that their advisors identify approaches that leverage amounts going to charity. Among them: tax efficient accounts to donate and keeping those accounts invested in the equity market. Individual Retirement Accounts can be efficient assets to leave to charity at the death of the client. Investing IRA accounts earmarked for charities in variable annuities with their death benefit guarantees may increase the client’s comfort level with keeping IRA accounts exposed to the risks of the equity markets.
Typically, IRA owners leave their IRA accounts to children. At the individual’s death, the IRA is included in the taxable estate and is subject to income taxation when distributions are made to the beneficiaries.
Alternatively, if the IRA is left to charity, the IRA avoids both estate and income taxation. The ability to transfer the entire IRA account to the charity without taxation results in significantly more dollars going to charity on an after-tax basis than the alternative of leaving the IRA to children and giving other assets to charity.
Retaining access to funds in an IRA and avoiding an income tax trap are the 2 primary reasons to transfer an IRA to charity at death rather than during the individual’s lifetime. If the individual retains the IRA, the funds are available to provide retirement income if necessary.
Giving IRA assets to charity during the individual’s life can be problematic. Distributions from the IRA are considered income and the individual receives a charitable deduction for the amounts given to a qualified charity. However, for some taxpayers, the charitable deduction may not directly offset the taxable income because of limits on charitable deductions and the phase-outs of itemized deductions.
The Pension Protection Act of 2006 includes a provision that addresses this issue and permits taxpayers to make direct transfers from their IRA accounts to a qualified charity. However, the charitable transfer provision is limited to $100,000 per year in 2006 and 2007 for taxpayers over the age of 70 1/2 .
When donors forego an immediate gift and plan for a bequest at death, they must decide how to invest the funds during their lifetime. At first glance, it may seem prudent to invest all or a significant portion of the funds in fixed investments to ensure the principal will be preserved for the charity. However, charitable organizations’ needs grow over time; their assets must therefore grow to keep pace with these needs–and with inflation.
Likewise, it is important to keep dollars that will transfer to charities invested in the stock market. While past performance is no guarantee of future results, the stock market has historically provided greater growth potential than have fixed investments.
Donors want to have the upside potential of keeping IRA dollars earmarked for charities invested in the stock market. However, the donor may want to avoid the downside risk. One solution is to invest the IRA assets in a variable annuity that has death benefit protections.
Annuities can be used to manage risk through investment diversification and insurance benefits. Death benefits offered on variable annuities differ by contract. Most variable annuities include a death benefit that guarantees a return of the original principal at the death of the contract owner.
Optional death benefits are also available at additional cost, such as the highest anniversary value and increasing (a.k.a. “rollup”) death benefit riders. Highest anniversary death benefits are equal to the greater of the contract value or highest anniversary value. Increasing death benefits are equal to the greater of contract value or the original principal grown at a specific percentage.
The VA gives the donor the ability to invest funds in the market and include the protection of the death benefit that is paid when the individual dies. The cost involved with this strategy includes the typical expenses associated with variable annuities, such as mortality and expense risk charges, administrative charges, rider fees, and deferred sales charges.
There may be opportunities to increase the benefits in the annuity and lower the costs. For example, the death benefits on most VAs today are reduced on a pro-rata basis with each withdrawal. Therefore, the client may benefit by taking required minimum distributions from an IRA that is not invested in the variable annuity.
The donor may pay more for the variable annuity with death benefit protection than for alternative investment options such as a diversified mutual fund portfolio. However, the death benefit features of a VA may provide your client with the necessary comfort level to keep IRAs earmarked for charity invested in equities.