Charitable Gift Annuities AND HOW THEY WORK

Generically, what is an annuity?

An annuity is an income stream from a pool of capital. It consists of blended payments of interest and capital. The capital is placed with the annuity-issuing institution (usually a life insurance company) and the institution pays the income to the annuitant at stated intervals such as monthly or quarterly. The amount of income is specified and the length of time for the payments to last is specified, such as for the beneficiary's lifetime, twenty years, whatever. In the early stages the income stream consists mainly of interest with a little principal; however the balance gradually shifts during the lifetime of the annuity so that, at the end, the entire principal is exhausted. In the case of life annuities, only life insurance companies issue them since there is an indefinite period during which the payments will continue, namely the lifetime of the beneficiary. Other financial institutions issue term certain annuities, those that last for a specified number of years whether or not the annuitant is alive.

Source of funds. The source of the funds dictates the taxation of annuity payments. If the capital sum comes from a government-registered source, such as a registered retirement savings plan or a registered pension plan, the payments will be fully taxable when received. This is because there was tax relief granted when the funds went in and on the interest or growth accumulations. However annuities that emanate from tax-paid funds are treated differently: only the earned interest portion is taxed and there is no tax on the capital being refunded. In most such cases the taxable portion can be fixed, or "prescribed" as a constant for the duration of the annuity since, otherwise, it would be heavily taxed during the early years and more lightly taxed closer to the end.

What does "prescribed" mean? This is a provision that permits the level taxation of the income over the lifetime of the annuity. It only applies to annuities purchased with non-registered funds since those purchased with registered funds are fully taxable. For example, an annuity paying $500 per month ($6,000 annually) might have as its "annual taxable portion" $3,000 if it is a “prescribed” annuity. For an annuity that is not prescribed, i.e. an “accrual” annuity, probably about $5,800 would be taxable the first year, $5,600 the second year, continuing to smaller and smaller amounts. With a prescribed annuity the $3,000 would remain the taxable portion for the lifetime of the annuity, regardless of who is receiving it.

Annuity options. With a term certain annuity the options are basically the number of years for which payments are to be made and the frequency of the payments. Life annuities have more options. For example, payments could continue until the death of both partners in a marriage or other relationship. Or there could be a reduction of the payment amount on the first death or on the death of the primary annuitant (the one whose money was used to purchase the annuity). Alternatively, the annuity could have a minimum guarantee, which might state that payments would continue for the lifetime of the annuitant but for at least fifteen years even if the annuitant dies before that. This ensures that at least some of the remaining funds would come to the heirs should the annuitant(s) die before the capital might reasonably have been exhausted through payouts.

What is a prescribed annuity for?

These instruments are ideal for a number of purposes. Following are some examples.

1. An individual may need to increase the income they may receive from accumulated capital, say, from the sale of a house, and this takes precedence over leaving an estate to heirs. A lifetime prescribed annuity would pay out a full interest return plus a portion of capital and this would be guaranteed not to run out before the death of the annuitant. About $60,000 of capital would purchase a monthly income of about $500 for a 75 year-old couple, no reduction on the first death, with a fifteen-year minimum guaranteed period. The annual taxable portion would be about $3,000. The same $60,000, if invested in term deposits at 7%, would produce a fully taxable income of about $4,200 annually. At a 50% income tax rate, the annuity would net about $4,500 whereas the term deposits would net about $2,100. Obviously the annuity provides a much higher after-tax income, but the $60,000 would no longer be a part of the annuitant's Estate. With the GIC’s, it would.
2. An individual is required to keep a life insurance policy going for the duration of his life due to some agreement such as a divorce settlement; he is required to guarantee the premiums will be paid. A prescribed annuity could be used to pay the premium but, should the insurance policy's beneficiary predecease him, he could drop the life insurance and take the annuity payments himself. Or he could donate either the annuity payments or the life insurance policy, or both, to his favourite charity.
3. An individual wants to endow his or her favourite charity: here are a few possibilities.
   • Using the figures in Example 1) above, the difference between the $4,200 fully taxable interest income (net income of $2,100) and the $6,000 partially taxable annuity income (net income of $4,500) could be donated to the charity each year, offsetting the taxation of the annuity. And beneficiary designation provisions could be made for the capital proceeds, if any, to be paid to the charity after the individual's death.
   • The charity could grant the annuity itself, making lower than market value payments, thus effectively having the use of the capital at a low interest rate. However, not a lot of charities are able to issue annuities themselves.

• The donor could donate the $60,000 to the charity on condition the charity purchase an annuity which would provide him or her with an after-tax income of somewhere between the $2,100 and the $4,500 figures mentioned above: for example, the cost of a life annuity of $3,000 annually, same annuity options, for the same 75 year old couple would be about $30,000, providing the recipient with about $2,250 after-tax annual income. This would leave for the charity the difference between the original $60,000 and the annuity cost of $30,000, about $30,000, which it could retain for its work. The donor would receive a charitable receipt for this balance, $30,000, for current income tax purposes.

What if I am not 75 years old? At 50 years old, you might have $50,000 on which you are earning 7% interest, yielding $3,500 annually ($1,750 after income tax). As a life annuity (with full benefits to your surviving spouse, also aged 50, and guaranteed payments for fifteen years in the event of both annuitants dying prematurely) this might earn for you about $3,800 annually of which about $2,100 would be taxable on a prescribed annuity basis, for an after-tax net income of about $2,800. The proceeds could be used for ten years to pay a life insurance premium on your life.

The $2,800 for ten years would purchase a death benefit of $150,000 (assuming you don't smoke). By irrevocably assigning the life insurance policy to the charity the premiums would become receiptable as a donation, actually providing you with a net income tax credit for the ten years of approximately $700 annually. After ten years you would get to keep the annuity payments (and pay tax on them) to supplement your retirement income: it is a joint life annuity providing lifetime income to yourself and your spouse. At your death the charity would receive the $150,000 proceeds of the life insurance policy. Not a bad use of $50,000: funding a $150,000 life insurance policy for the charity, providing a life income for you and your spouse, and anything left going to your beneficiaries or to the charity.

Another possibility is that you could donate the $50,000 to the charity on condition they arrange to pay you an income for the rest of your life, and your spouse's life, starting in ten years' time (your age 60). If you wanted all the income it would amount to about $8,000 (about $5,000 after tax), joint life, no reduction of income on the first death, and guaranteed for fifteen years from date of the first payment should both annuitants fail to survive very long. But this does away with the idea of providing a benefit to the charity.

However, the cost of providing these individuals with the same kind of annuity of $3,000 annually (about $2,000 after tax) starting at age 60 would be about $19,000. So, by giving the $50,000 to the charity now in return for the annuity of $3,000 annually starting in ten years, these individuals would receive a tax receipt for about $31,000, which sum the charity could use for current purposes. At their 50% tax rate, the $31,000 receipt would save the couple some $15,500 in income tax over the ensuing years.

Should a gift annuity be combined with life insurance? The answer is "maybe". Always if you are thinking about a gift annuity you should look into the possibility of a life insurance policy as a sort of estate replenishment vehicle. It is important to remember that an annuity takes assets out of your estate and transfers them somewhere else so you can receive guaranteed annuity payments that are larger than they would be if you retained the capital yourself and invested it. Often these payments are sufficiently larger than pure interest income, large enough to afford the life insurance premium and still leave you ahead of the game. It does not always work but the possibility should be explored.

Nuts and Bolts about how a gift annuity works. There is no magic. Regardless of who issues the annuity contract, actuarial tables are involved which imply life expectancy and other factors. What seems like magic is the income-tax-free environment in which a charity operates; obviously charities are and should be extremely careful to stay on side with the law that surrounds this aspect of their operation.

Some charities are authorized to issue life annuities themselves, subject to actuarial guidelines laid down by Canada Revenue Agency. If they do issue annuities, the charity will agree to pay a fixed and guaranteed amount to the beneficiary in return for receiving a specified capital sum. Depending upon the actuarial tables, your age, prevailing interest rates, and other factors, you would receive the charity's receipt for an amount roughly equivalent to the portion of the capital you would not be expected to live to collect in the form of annuity payments.

An example would be a 65 year-old male donating $100,000 to a charity with the charity’s promise to pay $5,000 annually to the donor. The donor would receive a tax receipt for $14,000 which is $5,000 multiplied by his actuarial life expectancy (17.2 years) and subtracted from the $100,000 original gift. He would not be taxable in this instance on the income received, as it would be deemed a return of capital.

However, if he wanted $10,000 annually, he would be expected to receive $172,000 from the charity. This would be treated as a prescribed annuity and he would be taxable on the additional $72,000 he would expect (actuarially) to receive back, annually at the rate of $4,186.05 of each $10,000. So the charitable annuity in this instance isn’t charitable.