ELITE ADVISOR BEST PRACTICES
Charitable Tax Savings with Private Placement Annuities
For accredited investors, PPAs provide an effective strategy for increasing charitable gifts at death by initially deferring, and ultimately avoiding, taxes on investment income during life.
By Michael King
- Generous individuals and families often make provisions for charitable gifts to be made at the time of their deaths.
- Private placement annuities provide an effective strategy for dramatically increasing charitable gifts at death by initially deferring, and ultimately avoiding, taxes on investment income during life.
- For accredited investors, private placement annuities provide important and significant benefits over traditional commercial annuities.
Individuals and families who are generous during their lifetimes are often also generous at death. Generosity through charitable gifts at the time of death can be expressed in any number of ways—and sometimes in creative manners.
Charitable Gifts at Death
The most common approach to giving is simply to gift a specific amount, or a percentage of one’s estate. For example, an individual might gift $100,000 or 10 percent of his or her estate to a favorite charity.
Some families treat charity as “another child” that shares in the total inheritance they plan to give to their children. For example, instead of providing an inheritance of $2.5 million to each of their four children, a couple with a $10 million estate might instead leave $2 million to each child, with the remaining $2 million gifted to one or more charitable organizations that they support.
Other families may determine a specific, targeted inheritance that they desire to leave their children and other heirs—and then pass the balance of their estate to charity. For example, a couple with a $5 million estate and two children might decide that $1 million to each child is an appropriate inheritance, and thus leave the $3 million balance of their estate to charity.
Regardless of how such charitable gifts are ultimately made, there are often opportunities to leverage significantly the amount of wealth passing to charity at death, by mitigating the associated income tax liability on such assets during the donors’ lives. Private placement annuities provide one such opportunity.
Private Placement Annuities Versus Traditional Annuities
Annuities in general are contracts with insurance companies that allow for investment accumulation on a tax-deferred basis. Unlike other tax-deferred vehicles such as qualified retirement plans [IRAs, 401(k), etc.], there are no restrictions on the amount of assets that can be contributed to an annuity.
Private placement annuities differ from traditional commercial annuities in several important ways, thereby providing enhanced benefits. First, unlike traditional annuities, which are broadly available to the general public, private placement annuities are available only to accredited investors—those who can prove that they meet minimum thresholds of income and wealth.
Second, the overall cost structure of private placement annuities is generally dramatically less than traditional commercial annuities—often one-half or even one-third of the cost. There are no upfront charges on premium investments, and there are no back-end assessments or surrender charges on withdrawals.
Variable annuities allow premium contributions to be invested in separately managed investment accounts with investment options that are very similar to common mutual funds. Private placement annuities, which can include hedge funds and alternative investments, are almost always structured as variable contracts, and provide significantly enhanced investment options over traditional annuities. Withdrawals can be made from private placement annuities at any time without penalty or surrender charges. Traditional annuities, on the other hand, often have significant restrictions on the number of withdrawals that can be made, particularly in the early years of the contract, and generally impose surrender charges on withdrawals made in those early years.
In both cases, withdrawals are subject to ordinary income taxes on any gain component, regardless of the underlying nature of the income. For example, income that would otherwise be taxed as qualified dividend income or capital gain income will nonetheless be taxed as ordinary income upon withdrawal. Because of this adverse tax treatment of withdrawals, tax-inefficient investments such as hedge funds and alternative investments, as well as assets that produce ordinary income, are often favored investments inside annuities. In addition, withdrawals made prior to age 59½ are subject to a 10 percent excise tax on the gain component of the distribution.
Turning Tax Dollars into Charitable Dollars
In the context of private placement annuities that are planned to be given to charity upon death, the tax implications described above have less importance. That’s because the overall intent is for the underlying assets of the annuity to be passed on to charity, and thus avoid taxation entirely. Income that is initially tax-deferred ultimately becomes tax-free. Over a period of 10, 20 or even 30 years, the amount of tax avoided on this investment income can be extraordinary.
The following example illustrates the magnitude of the potential tax savings. Blaine and Donna have $20 million of liquid assets, of which $5 million will never be needed to provide income for their financial support or for the inheritance of their two children. They are very charitable and plan on leaving a significant portion of their estate to charity upon the second spouse’s death. Blaine and Donna have decided to leave each of their children an inheritance of $5 million, with their remaining estate passing to charity.
Five million dollars of their investment portfolio is being managed with a goal of achieving total return, not income tax efficiency. The portfolio’s objective is to average a net annual return of 8 percent after investment management fees of 1 percent. Blaine and Donna anticipate that this return will be subject to a blended income tax rate of approximately 30 percent. Under these assumptions, the $5 million sum will grow to over $8 million in 10 years, and to over $14 million in 20 years.
In light of the fact that these investment assets will eventually pass to charity, and as an alternative to investing in a taxable account, Blaine and Donna contribute $5 million to a private placement variable annuity. Blaine and Donna name their donor-advised fund (DAF) as the beneficiary of the annuity, which provides enhanced flexibility in determining the ultimate charities that will receive grants from them. After Blaine and Donna have both passed away, the annuity balance will be paid to their DAF with no income tax or federal estate tax consequences.
The $5 million accumulated in the annuity at the same 8 percent net rate of return, and net of the costs and expenses of the annuity itself, totaling 65 basis points, will grow to almost $9.5 million in 10 years and to over $19 million in 20 years—more than double the initial amount invested. Therefore, after 10 years, the total tax savings provided by the annuity over the taxable account exceeds $1.3 million, and after 20 years it will be over $5 million.
In this manner, Blaine and Donna can dramatically increase the amount of assets that they’re able to give to charity by effectively eliminating income taxation on assets that have already been earmarked for charity at death. Over the course of many years, they will convert millions of tax dollars into charitable dollars.