I often ask clients, "What is your charitable intent?" Most respond by saying it's not significant. But when I ask the same clients if they would be interested in learning how to use the tax law to enrich their families while giving to charity and saving taxes at the same time, the reply is usually positive.
The case study that follows uses a $10 million target endowment. But don't focus too much on the numbers because they can easily be lowered or raised to meet your goals.
Now the facts: Ben and Mary want to create a $10 million endowment at their favorite charity to honor their deceased son. They don't feel comfortable making such a large gift during their lifetime. They fear inflation and don't want to reduce the income level (dividends and interest) of their conservative investment portfolio. Also, they would like to find some way to keep the gift from reducing the inheritance of their three surviving children.
Ben and Mary are willing to commit the full $10 million to a charitable plan now, as long as their goals of maintaining an income level and not reducing the inheritance of their kids are fulfilled. They are in a 35 percent income tax bracket and a 50 percent estate tax bracket. Even if the rates change, the strategies used in this study remain the same.
The following is the four-step plan we implemented for Ben and Mary:
Step 1: They bought a joint and survivor annuity, which pays as long as either is alive, for $4 million. It yields 6.6 percent or $264,000 (6.6 percent × $4 million) per year. The prior annual earnings of the $4 million were $108,000. So, the $264,000 is $156,000 more than the old annual earnings of $108,000 that were fully subject to income tax. The bonus is that 59.4 percent of the $264,000 (or $156,816) is income tax free. After considering the income tax savings, Ben and Mary will have an additional $156,000 per year of spendable income (as an inflation hedge).
Step 2: Their favorite charity buys a $10 million SPLI (premium of $3 million gifted by Ben and Mary) to fund the endowment when both Ben and Mary have passed on.
Step 3: Ben and Mary enjoy income tax savings of $1,050,000 for the $3 million gift in Step 2. They created an irrevocable life insurance trust (ILIT) to buy a $10 million second-to-die, 15-year pay premium policy. The same amount would be paid each year for 15 years, with premiums stopping thereafter. The annual premium is $212,800 per year or a total of $3,192,000 (15 years × $212,800). The $1,050,000 income tax savings (plus interest earned), together with the additional $156,000 yearly in Step 1, should easily cover the annual premium payments.
Step 4: You might call this the "extra-cautious step." We asked Ben and Mary to keep the extra $3 million in a separate interest earning investment. Remember, Ben and Mary were willing to commit $10 million to the four-step plan. However, we only used $7 million ($4 million in Step 1 and $3 million in Step 2).
The extra $3 million serves as protection for any small amount that may be needed to pay the premiums in Step 3. It also serves as a hedge against inflation. As the years progress, inflation or some other need might require Ben and Mary to increase their spendable income. In this case, a portion of the $3 million in the separate account can be used to purchase a new annuity.
If inflation does rears its ugly head, then the annual dollar annuity amount would be larger for two reasons: 1) inflation increases annuity rates; and 2) as Ben and Mary get older, the rate for a commercial annuity rises.
Let's summarize the plan created for Ben and Mary:
- Their after-tax annual income for the $4 million is more than doubled (Step 1).
- Their favorite charity will get $10 million (Step 2).
- Their family will get $10 million (Step 3).
- The real economic value of the $10 million committed to the plan (after 50 percent estate taxes) is only $5 million. In effect, we transformed $5 million into $20 million ($10 million each for their favorite charity and the family). Of course, there still is an extra $3 million, as a contingency, in Step 4.
One final point: The $20 million to their favorite charity and the family was divided 50:50 by Ben and Mary. You can change the ratio (to 60:40, 70:30 and so on) to favor the favorite charity or the family, as you see fit. One final warning: Only work with experienced advisors when you play this type of charity-tax game.
Do you want to learn more about saving taxes, giving to charity and multiplying your family's wealth? Just go to my Web site, www.taxsecretsofthewealthy.com, and click on "Personally Designed Philanthropy."