When developing your estate plan, you can do well by doing good. Charitable giving rewards you in many ways. It gives you a sense of personal satisfaction, and it can save you money in transfer taxes.
A few words about estate taxes and charitable giving
The federal government taxes transfers of wealth you make to others, both during your life and at your death. Generally, the federal gift and estate tax is imposed on transfers more than $11,580,000 (in 2020) and at a top rate of 40 percent.
There is also a separate generation-skipping transfer (GST) tax that is imposed on transfers made to grandchildren and lower generations. There is a $11,580,000 (in 2020) GST tax exemption and the GST tax rate is 40 percent.
You may also be subject to state transfer taxes.
Careful planning is needed to minimize transfer taxes, and planned giving can play an important role in your estate plan. By leaving money to charity, the full amount of your charitable gift may be deducted from the value of your gift or taxable estate.
The best property for charitable giving
Giving to charity is not only personally satisfying, the IRS also rewards you with generous tax breaks!
- Current income tax deduction if you itemize, subject to certain percentage limitations for any one year
- Tax benefit received reduces the net out-of-pocket cost of the donation (e.g., a $100 donation from someone in a 30 percent tax bracket has a net cost of $70)
- Reduces or eliminates capital gains tax if appreciated property is given
- No gift or estate taxes imposed
- Removes any future appreciation of the donated property from your taxable estate
Types of property for charitable giving
- Easy to give — the type of donation most charities like best
- Be sure to get a receipt or keep a bank record, regardless of the amount
Tangible personal property, such as:
Highly appreciated or rapidly appreciating property, such as:
- Intangible personal and real property (e.g., stock or real estate)
- Tangible personal property (e.g., art, jewelry)
Income-producing property, such as:
- Artwork (if given by the artist)
- Section 306 stock (stock acquired in a nontaxable corporate transaction)
Remainder interests in property
- Let’s you use the property, or income from the property, until a later date.
- Gift and estate tax deductions are not allowed unless a trust is used.
- You may only take the income tax deduction in the year that the gift is actually conveyed.
Caution: You may need to have certain types of property appraised.
Life insurance and charitable giving
Life insurance can be an excellent tool for planned giving. Not only does life insurance allow you to make a substantial gift to charity at relatively little cost to you, but you may also benefit from tax rules that apply to gifts of life insurance.
Why use life insurance for charitable giving?
Life insurance allows you to make a much larger gift to charity than you might otherwise be able to afford.
Although the cost to you – your premiums – is relatively small, the amount the charity will receive – the death benefit – can be quite substantial. As long as you continue to pay the premiums on the life insurance policy, the charity is guaranteed to receive the proceeds of the policy when you die.
Since life insurance proceeds paid to a charity are not subject to income and estate taxes, probate costs, and other expenses, the charity can count on receiving 100 percent of your gift.
Giving life insurance to charity also has certain income tax benefits.
- Depending on how you structure your gift, you may be able to take an income tax deduction equal to your basis in the policy or its fair market value (FMV).
- And you may be able to deduct the premiums you pay for the policy on your annual income tax return.
- When an insurance contract is transferred to a charity, your income tax charitable deduction is based on the lesser of FMV or adjusted cost basis.
What are the disadvantages of using life insurance for charitable giving?
Donating a life insurance policy to charity (or naming the charity as beneficiary on the policy) means that you have less wealth to distribute among your heirs when you die. This may discourage you from making gifts to charity.
However, this problem is relatively simple to solve…buy another life insurance policy that will benefit your heirs instead of a charity.
Ways to give life insurance to charity
The simplest way to use life insurance to give to a charity is to name a charity to receive the benefits of your life insurance policy. You, as owner of the policy, simply designate the charity as beneficiary.
Designating the charity as beneficiary may allow you to make a larger gift than you could otherwise afford from your other assets.
If the policy is a form of cash value life insurance, you still have access to the cash value of the policy during your lifetime. However, this type of charitable gift does not provide many of the income tax benefits of planned giving, because you retain control of the policy during your life. When you die, the proceeds are included in your gross estate, although the full amount of the proceeds payable to the charity can be deducted from your gross estate.
Another alternative is to donate an existing life insurance policy to charity.
To do this, you must assign all rights in the policy to the charity. You must also deliver the policy itself to the charity. By doing this, you give up all control of the life insurance policy forever. This strategy provides the full tax advantages of charitable giving because the transfer of ownership is irrevocable.
You may be able to take an income tax deduction equal to the lesser of your adjusted cost basis or FMV. The policy is not included in your gross estate when you die, unless you die within three years of the transfer. In this case, your estate would get an offsetting charitable deduction.
A creative way to use life insurance to donate to a charity is for the charity to insure you. To use this strategy, you would allow the charity to purchase an insurance policy on your life. You would make annual tax-deductible gifts to the charity in an amount equal to the premium, and the charity would pay the premium to the insurance company.
One final method is to use a life insurance policy in conjunction with a charitable remainder trust.
This strategy is relatively complex (it will require an attorney to set up), but it provides greater advantages than other, simpler methods. You set up a charitable remainder trust and transfer ownership of other, income-producing assets to the trust.
The income beneficiary of the trust (you or whomever you designate) will get the income from the assets in the trust.
At the end of the trust term (which might be a certain number of years or upon the occurrence of a certain event, such as your death), the property in the trust would pass to the charity.
You’ll receive a current tax deduction when you establish the trust for the FMV of the gifted assets, reduced according to a formula determined by the IRS.
Life insurance can then be purchased (usually inside an irrevocable life insurance trust to keep the proceeds out of your estate) to replace the assets that went to the charity instead of to your heirs.
Make an outright bequest in your Will
The easiest and most direct way to make a charitable gift is by an outright bequest of cash in your Will.
Making an outright bequest requires only a short paragraph in your Will that names the charitable beneficiary and states the amount of your gift.
The outright bequest is especially appropriate when the amount of your gift is relatively small, or when you want the funds to go to the charity without strings attached.
Make a charity the beneficiary of an IRA or retirement plan
If you have funds in an IRA or employer-sponsored retirement plan, you can name your favorite charity as a beneficiary.
Generally, a spouse, child, or other individual you designate as beneficiary of a traditional IRA must pay federal income tax on any distribution received from the IRA after your death.
By contrast, if you name a charity as beneficiary, the charity will not have to pay any income tax on distributions from the IRA after your death (provided that the charity qualifies as a tax-exempt charitable organization under federal law), a significant tax advantage.
After your death, distributions of your assets to a charity generally qualify for an estate tax charitable deduction. In other words, if a charity is your sole IRA beneficiary, the full value of your IRA will be deducted from your taxable estate for purposes of determining the federal estate tax (if any) that may be due. This can also be a significant advantage if you expect the value of your taxable estate to be at or above the federal estate tax exclusion amount.
Naming a charity as beneficiary can provide double tax savings.
- First, the charitable gift will be deductible for estate tax purposes.
- Second, the charity will not have to pay any income tax on the funds it receives.
This double benefit can save combined taxes that otherwise could eat up a substantial portion of your retirement account.
Of course, there are also nontax implications.
If you name a charity as sole beneficiary of your IRA, your family members and other loved ones will obviously not receive any benefit from those IRA assets when you die. If you would like to leave some of your assets to your loved ones and some assets to charity, consider leaving your taxable retirement funds to charity and other assets to your loved ones. This may offer the most tax-efficient solution, because the charity will not have to pay any tax on the retirement funds.
If retirement funds are a major portion of your assets, another option to consider is a charitable remainder trust (CRT). A CRT can be structured to receive the funds free of income tax at your death and then pay a (taxable) lifetime income to individuals of your choice. When those individuals die, the remaining trust assets pass to the charity.
If retirement funds are a major portion of your assets, another option is to name the charity and one or more individuals as co-beneficiaries.
Use a charitable trust
Another way for you to make charitable gifts is to create a charitable trust.
There are many types of charitable trusts, the most common of which include the charitable lead trust and the charitable remainder trust.
A charitable lead trust pays income to your chosen charity for a certain period of years after your death. Once that period is up, the trust principal passes to your family members or other heirs. The trust is known as a charitable lead trust because the charity gets the first, or lead, interest.
A charitable remainder trust is the mirror image of the charitable lead trust. Trust income is payable to your family members or other heirs for a period of years after your death or for the lifetime of one or more beneficiaries. Then, the trust principal goes to your favorite charity. The trust is known as a charitable remainder trust because the charity gets the remainder interest.
Depending on which type of trust you use, the dollar value of the lead (income) interest or the remainder interest produces the estate tax charitable deduction.
Why use a charitable lead trust?
The charitable lead trust is an excellent estate planning vehicle if you are optimistic about the future performance of the investments in the trust. If created properly, a charitable lead trust allows you to keep an asset in the family while being an effective tax-minimization device.
For example, you create a $1 million charitable lead trust. The trust provides for:
- Fixed annual payments to ABC Charity for 25 years of $50,000 (or 5% of the initial $1 million value of the trust).
- At the end of the 25-year period, the entire trust principal goes outright to your beneficiaries.
To figure the amount of the charitable deduction, you must value the 25-year income interest going to ABC Charity. To do this, you use IRS tables.
Based on these tables, the value of the income interest can be high — for example, $900,000. This means that your estate gets a $900,000 charitable deduction when you die, and only $100,000 of the $1 million gift is subject to estate tax.
Why use a charitable remainder trust?
A charitable remainder trust takes advantage of the fact that lifetime charitable giving generally results in tax savings when compared to testamentary charitable giving.
A donation to a charitable remainder trust has the same estate tax effect as a bequest because, at your death, the donated asset has been removed from your estate. Be aware, however, that a portion of the donation is brought back into your estate through the charitable income tax deduction.
Also, a charitable remainder trust can be beneficial because it provides your family members with a stream of current income — a desirable feature if your family members won’t have enough income from other sources.
For example, you create a $1 million charitable remainder trust. The trust provides for:
- Fixed annual payments to your beneficiaries for a period not to exceed 20 years.
- At the end of the 20-year period, the entire trust principal goes outright to ABC Charity.
To figure the amount of the charitable deduction, you must value the remainder interest going to ABC Charity, using IRS tables. This is a complicated numbers game. Trial computations are needed to see what combination of the annual payment amount and the duration of annual payments will produce the desired charitable deduction and income stream to the family.
The legal and tax issues discussed here can be complex. Be sure to consult an estate planning attorney, your financial advisor and the planned giving officer at your favorite charity for further guidance.