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A New Look at Charitable Bequests Continuing our review of the effect of recent changes in estate tax law on some of our most powerful marketing strategies, we will examine the gift of deferred annuity assets to charity at death. Due to the billions of dollars in such annuities -- fixed and variable -- this technique may be one of the most important additions to financial planning strategies since charitable remainder trusts emerged. Case Study Paul and Sarah Montgomery, ages 65 and 60, have Net Worth of almost $3,500,000. (Click here for a breakdown of their financial data.) One of their assets is a tax deferred annuity worth $500,000 containing a cost basis of $300,000. Assume it is a variable annuity growing at 10% and subject to a management fee of 1% and a death benefit guarantee fee of .75%. Due to estate taxes and income in respect of a decedent (IRD), the death tax on this annuity is slightly over $332,000, 62% of its current value. It only gets worse! In 15 years, death taxes eat up 71%, and in 30 years, 78%. You can review this evolving tax trap in summary and in detail by clicking here. One of the economic oddities associated with deferred annuities is that, although they are typically purchased because of their tax deferral, once the money is in the annuity, most wealthy clients are reluctant to access those funds since withdrawals are taxable (to the extent of gain). They, therefore, tend to utilize other income sources -- not the annuity. Unlike pension funds, there are no required minimum distributions associated with deferred annuities. With pensions, the required distributions retard the growth of the pension fund; however, with deferred annuities there is no such brake on accumulation values. Therefore, the death tax issues normally associated with pensions are much worse, long-range, with annuities. For example, had Paul and Sarah's annuity value of $500,000 been in pension funds, using similar assumptions, its value in 30 years would be projected to be a little over $1,100,000. The annuity's value, with no required minimum distributions to retard growth, is over $5,100,000. Normally, one would be pleased with the higher value -- except, in the case of the annuity, the IRS is waiting with a tax net to confiscate as much as 78%. Further, unlike pensions, there is no way to "stretch out" the income tax bite on deferred annuities as is available with pensions through timely naming of next-generation beneficiaries. Solution: The entire problem can be easily solved by making a charity or family foundation the ultimate beneficiary of the deferred annuity. In this way, its funds are still available while either Paul or Sarah is alive. At death, the charity inherits the money, not the IRS. The graphic below shows the results. Strategy 1 is the status quo, and Strategy 2 shows the results of the charitable beneficiary designation. Notice in the Net Worth graph (upper left), there is no financial impact during Paul and Sarah's lives. Their heirs (lower right) suffer a long-range loss of a little over $1,000,000; however, the charity selected is the long-range beneficiary of a little over $5,100,000. Only a miser would fail to be moved by such charitable leverage.
Let's see if we can't improve the wealth to heirs through the use of a wealth replacement trust ("WRT") funded with life insurance. As you know, a WRT is an irrevocable life insurance trust which owns a life insurance policy insuring, in this case, Paul and Sarah, the purpose of which is to replace the wealth diverted to charity -- without the involvement of the IRS. The policy we will use to demonstrate this approach is variable survivor life with $1,200,000 of increasing death benefit funded by gifts to the WRT of $12,000 a year. The graphic below shows the results. Due to the gifts required to fund the WRT, the graph on the upper left shows a small dent in Paul and Sarah's Net Worth. The wealth to heirs (lower right) is always greater, and the favored charity (lower left) is still the long-range beneficiary of a little over $5,100,000.
The graphics below compare the results from a different perspective. As you can see, over the mid-term, this charitable strategy reduces taxes by almost $1,300,000, increases wealth to heirs by almost $900,000, and produces over $1,600,000 for charity. 15th Year
Over the long-term (30 years), taxes are reduced by almost $4,700,000, the heirs are slightly ahead, and the charity receives more than $5,100,000. 30th Year
The wealth to heirs can be fine-tuned up or down through adjustments to the size of the policy in the WRT. The larger the policy, the more the dent in Paul and Sarah's Net Worth, and the greater the wealth to heirs. The graphic below shows the result of increasing the policy size to $2,500,000 (increasing death benefit) with premiums of $25,000. In this case, Paul and Sarah's Net Worth appears to be tolerably impacted while their heirs are significantly better off in all years. The charity continues to be the long-range beneficiary of a little over $5,100,000.
Conclusion: No matter how this approach is measured, it presents a powerful new planning alternative for those with deferred annuities. If paid, say, to a family foundation, a charitable gift forms part of overall family-controlled wealth. From this perspective, the heir's inheritance and the charitable gift produce a long-range total in excess of $13,000,000.
Frequently Asked Questions About Charitable Bequests of Deferred Annuities Would the numbers look different if the plan were a fixed annuity? Since a fixed annuity would have less aggressive growth potential, one would expect the charity's gift to be reduced; however, a fixed annuity injected into the scenarios above would produce a relatively similar result. Can the surviving spouse be designated as beneficiary of the annuity ahead of the charity? Yes. When the surviving spouse dies, the charitable beneficiary designation then becomes operational. Can a charitable beneficiary designation on an annuity be revoked? Yes. Are there restrictions on accessing funds in the annuity during Paul and Sarah's lifetime? No. The annuity values are freely accessible at any time prior to death. What if estate taxes are fully repealed after 2010? Is there a need for this strategy? Yes, since a large portion of the transfer tax on a deferred annuity is income tax, a charitable beneficiary designation would continue to be worthwhile and, as indicated above, the entire transaction could be revoked prior to death should future circumstances dictate. Can different charities benefit from the funds? Yes. One of the easiest ways to do this is to make the charitable beneficiary a "donor-advised" account at a public operating charity. Many Community Foundations offer this option although the funds must usually be distributed only to local charities. For more flexibility, consider charitable organizations that offer this service on a national and international basis. Two organizations that do this are:
Some companies issue deferred annuities with extra death benefits. Does this avoid the need for a charitable beneficiary on the annuity coupled with the wealth replacement trust? No. First, there is typically a charge for this extra benefit, usually 15 to 35 basis points, and this can seriously retard the growth of the annuity's values. Second, the extra death benefit is usually limited to the low six figures which is simply too low for significant estate planning use. Third, the extra death benefit in these arrangements expires at or around age 80 -- so it cannot be counted on through most clients' life expectancies. Fourth, unlike the life insurance in the wealth replacement trust, the extra death benefit tied to an annuity is subject to estate taxes. Illustration Comments: We used version 6.0 of InsGiftÒ -- the Wealthy and WiseÔ System ("InsGift") for the analysis, and the graphics that appear in this issue are from that version. InsGift users can review all reports and related menu inputs for the plan presented in this article by downloading the InsGift Workbook named "MA130.!IG" from the Workbook Download section of this website. (To download this Workbook now, click here. To do so later, go to our main webpage, click on Producer's Center, then click on the Workbook Download icon at the top of the next page.) After downloading the Workbook, you can import it into your InsGift System by clicking on Client Workbook/Import Workbook on the Main Toolbar of InsGift. If you are not licensed for InsGift, please contact InsMark at 1-888-InsMark (467-6275) for licensing information. Computer Business Card: InsMark has released a new Computer Business Card ("CBC") in a PowerPoint format that presents the logic of charitable beneficiaries of deferred annuities, and it follows the general logic of this article. CBC licensees are authorized to make unlimited copies for distribution to clients, advisers, and charities. Most charitable organizations do not know how to make a convincing case for naming themselves beneficiaries of an annuity. With this CBC, you can help them do so convincingly. For CBC licensing information, contact an InsMark Account Executive at 1-888-InsMark (467-6275). Members of InsMark's Power Producers Marketing Group receive all CBCs on a complimentary basis. |
