Testamentary Gift Annuities
Written by Frank Minton, Ph.D.   

A testamentary gift annuity is any type of gift annuity where the donor is deceased at the time the annuity is established. The annuity could be immediate, deferred, or flexible deferred. The payments could be to one annuitant, or to two annuitants concurrently or successively.

Surveys conducted by the American Council on Gift Annuities (ACGA) have not sought information about the number of testamentary gift annuities that have been funded or arranged, but based on anecdotal evidence and the lack of attention to the subject at conferences and seminars, it would appear that they are relatively uncommon. That is unfortunate because there are a number of instances when a testamentary gift annuity could be an ideal way to meet donor objectives.

This paper is intended to stimulate consideration of testamentary gift annuities by discussing, in turn, (1) the procedure for their creation, (2) determination of the size of payments, (3) the tax implications, and (4) some case studies where a testamentary gift annuity would make sense.

How to Create a Testamentary Gift Annuity

The preferred way to create a testamentary gift annuity depends on how the annuity will be funded.

Testamentary gift annuity funded with investment assets, such as securities, held in the name of the donor or a living trust established by the donor.

Include language in a donor’s will or living trust authorizing a gift to a charity from the donor’s assets in exchange for payments to one or two individuals. The language, of course, must identify the annuitant(s) and provide instructions for determining the amount of the contribution and the size and frequency of the payments, and it can also state the intended charitable purpose of the gift.

Once the amounts of the contribution and payments are determined, following the death of the donor, enter this information in a gift annuity agreement drafted by the charity and signed by the charity and the donor’s personal representative, or by the charity and the donor’s trustee, in case the assets come from a living trust. Such documentation is recommended because a gift annuity agreement is expected by officials in certain regulated states.

Testamentary gift annuity funded with remaining assets in the donor’s retirement plan

First, the donor completes a beneficiary designation form designating that upon his or her death, the assets, or a percentage of the assets remaining in the retirement plan, shall be paid to the charity. The administrator of the plan will probably have a specific beneficiary form to be used for this purpose.

Second, the donor and the charity execute a gift annuity agreement in which the charity agrees to pay a life annuity to one or two named annuitants in exchange for whatever funds the charity receives, describes how the amount of the payments is to be determined, and indicates the purpose of the gift.

Following the death of the donor, when the value of the assets transferred and the amount of the payments are determined, it is recommended that a gift annuity agreement, with all of the numbers and details inserted, be completed and attached to the gift annuity agreement originally signed by the charity and the donor. Such documentation should satisfy officials in regulated states.

A testamentary gift annuity, like a charitable bequest, is a revocable gift. It can be entirely cancelled or reduced in size by modifying or deleting language in a will or living trust, or by changing the beneficiary of a retirement plan.

In the case of a testamentary gift annuity, the charity’s obligation starts at the donor’s death, but sometimes there is a delay before the distribution from the donor’s estate. The charity will want to take steps to shorten this time, and it might propose language delaying he first payment until the end of the period following the distribution for the annuity.

Determination of the Contribution and Payment Amounts

If a contribution for a gift annuity is made during the donor’s lifetime, the donor knows both the amount of the contribution and the size of the payments. However, in the case of a testamentary gift annuity, the donor will know either the amount (or approximate amount) of the contribution or the size of the payments, but not both.

When the donor arranges to contribute cash or other assets of a known value that are owned personally or in a living trust, the size of the payments will depend on when the donor dies and what the annuity rate paid by the charity is at that time. The language in the will or living trust will state that the annual payments will be the amount contributed, multiplied by the gift annuity rate then paid by the charity to a person (persons) of the annuitant’s (annuitants’) age(s) at the time of the donor’s death.

When the donor wants to assure annuity payments of a certain size, the amount that must be contributed will be the annual payment divided by the applicable gift annuity rate. The language in the will or living trust will state that the contribution amount shall be the annual payment divided by the gift annuity rate then paid by the charity to a person (persons) of the annuitant’s (annuitants’) age(s) at the time of the donor’s death.

It works the same way when the testamentary gift annuity is to be funded with all or a portion of remaining funds in a retirement plan except that the exact amount to be paid to the charity may not be known in advance. That is because the administrator of retirement plans generally want the beneficiary form to provide for payments of certain percentages of remaining funds rather than dollar amounts.

If the charity always follows the rates recommended by the American Council on Gift Annuities, “then suggested by the American Council on Gift Annuities” above could be substituted for “then paid by the charity.” The rates suggested by the ACGA could go up or down between the date the donor arranges the testamentary gift annuity and the date of the donor’s death, so it would be unwise for a charity to commit to today’s rates when helping a person arrange a testamentary gift annuity. Since the ACGA rates are based on historical and current investment data and on recent mortality experience, committing to whatever ACGA rates are in effect at the time the testamentary gift annuity is funded protects the charity against undue risk. If rates should drop to a level unacceptable to the donor, the donor always has the option of cancelling the annuity provision.

Tax Implications

Estate tax charitable deduction

The donor will be entitled to an estate tax charitable deduction if the annuity is, in fact, funded with the donor’s estate assets. The deduction amount is the contribution for the annuity less the present value of the annuity interest paid to the annuitant(s).

The present value of that annuity interest is a taxable gift, but in very few instances will any federal estate tax actually be owing because of the currently large exemption ($12,920,000 per person in 2023). Sometimes, in a state with a state estate tax, there could be some state estate tax even if no federal estate tax because the state exemption is considerably less than the federal exemption. Even so, estate tax is unlikely to be an issue for individuals who arrange a testamentary gift annuity.

Income tax charitable deduction

The donor will receive no income tax charitable deduction at the time of arranging a testamentary gift annuity because the gift is revocable. If a current income tax deduction is one of the objectives, then the donor should fund the annuity while living.

Taxation of payments if annuity is funded with cash or securities held in the name of the donor or a living trust established by the donor.

There is one major income tax benefit from a testamentary gift annuity funded with property personally owned by the donor or in the donor’s living trust. That is the step-up in basis applicable to the testator’s assets. Suppose, for example, that Margaret arranges a testamentary annuity for her younger sister and dies when her sister is aged 75. In Margaret’s portfolio is some stock valued at $100,000 which she purchased for $20,000, and she had designated it to fund the gift annuity. Because of the step-up in basis allowed for Margaret’s estate assets, for the duration of her sister’s life expectancy, $4,165 of her sister’s annual payments of $6,600 will be tax-free – the same as if cash had been contributed. If Margaret had established the gift annuity while living, she would have incurred considerable up-front taxable gain. That is because the portion of the $80,000 of gain attributable to the present value of the payments would have been taxable, and that gain cannot be ratably reported when the annuitant is someone other than the donor.

Taxation of payments when the annuity is funded with remaining assets in the donor’s retirement fund.

Prior to 2002, there had been a number of rulings and commentary regarding testamentary charitable remainder trusts funded with remaining retirement funds but not about testamentary gift annuities so funded. That changed with the issuance of PLR 200230018 regarding a testamentary gift annuity funded with remaining assets in an IRA. The critical point of this ruling was that neither the donor’s estate nor the charity (as beneficiary) would have to pay income tax on the IRA assets distributed to the charity. While the PLR dealt specifically with proceeds from an IRA, presumably it would also be applicable to other types of retirement funds and IRD items.

The IRS did not specifically rule on the taxation of payments to the annuitant, but it seems reasonable to conclude that, unless the IRA or other retirement plan was partially funded with after-tax dollars, that the annuity payments will be entirely taxable as ordinary income when received by the annuitant.

In summary, if a testamentary gift annuity is funded by cash or assets that would receive a step-up in basis, a substantial portion of the payments will be tax-free to the annuitant for the duration of the annuitant’s life expectancy, but if the annuity is funded with IRD assets, such as retirement funds, the payments will be entirely taxable as ordinary income. Of course, if an individual were named directly as a beneficiary of an IRD asset, distributions would likewise have been taxed as ordinary income.

Case Studies

Assuring that subsidies continue

Marcia has a younger sister, whose retirement income is scarcely enough to meet her basic needs. Marcia has been supplementing her sister’s income with annual gifts totaling about $25,000. A charity that Marcia regularly supports has proposed to her that she establish a gift annuity that would pay her sister $25,000 per year in quarterly installments. However, Marcia hesitates to do that because a gift annuity paying $25,000 per year to her sister, now aged 72, would require a contribution of slightly over $400,000. Marcia prefers to retain control of her capital for her own security, and to base future gifts on her sister’s situation.

Marcia amends her will to provide that, if her sister survives her, a bequest is to be made to the charity in exchange for a gift annuity, and that the amount of the bequest is $25,000 divided by the recommended ACGA gift annuity rate for an annuitant of Marcia’s sister’s age at the time of Marcia’s death. The will further provides that if Marcia’s sister predeceases her, an outright gift of a stated amount be given to the charity.

Marcia dies at the age of 82, and she is survived by her sister, who at the time is age 78. Marcia’s personal administrator delivers to the charity $347,222 of cash per an agreement to pay Marcia’s sister an annual annuity of $25,000. Of this amount $16,475 will be tax-fee for the duration of the sister’s life expectancy. Thereafter, if the sister is still living, her entire payment will be ordinary income.

Testamentary gift annuity as a replacement for the stretch IRA

The SECURE Act of 2019, with certain exceptions, requires that retirement funds given to non-spousal beneficiaries be fully distributed to them within 10 years. Prior to the SECURE Act, payments not only to a surviving spouse but to any non-spousal beneficiary could be made over the beneficiary’s lifetime. When payments from an IRA were made over the beneficiary’s life, it was known as a “stretch IRA.” The stretch IRA offered several benefits: tax-free growth for a long time; distributions taxed at a lower rate because they would be smaller than if they were bunched in a limited number of years; and prevention of imprudent beneficiaries’ quickly burning through an inheritance.

Philip had been planning on a stretch IRA for his son, Chris, but the SECURE Act prevented this arrangement. In lieu of it, he decided to arrange a testamentary gift annuity funded with remaining funds in his IRA. To effect this, he followed the procedure described above: named the charity as beneficiary of the IRA and executed a gift annuity agreement, with the charity providing for life payments to Chris equal to the amount distributed to the charity from the IRA multiplied by the recommended ACGA gift annuity rate for a person Chris’s age at the time of Philip’s death.

Assume that Philip dies at aged 85 when Chris is aged 60, and that the IRA balance at the time is $1,000,000. Chis will be paid $49,000 per year for life. If he had simply named Chris as the individual beneficiary, Chris would have been required to empty the IRA within 10 years, and the larger payments would likely have pushed him into a higher tax backet.

It would be possible to fund the gift annuity with any IRD assets, such as funds in a 401(k) or 403(b).

The security of fixed income without management responsibility

George and Linda discussed how they would like to provide for their three children – Daniel aged 62, Suzanne aged 60, and Ronald aged 57. The discussion has become more urgent because George is in failing health. They create an estate plan providing that at the first death most of their assets pass to or for the benefit of the surviving spouse, and that the children receive most of their financial legacies at the death of the second parent. George and Linda want each child to receive certain assets to use at his or her discretion plus a fixed sum to assure a basic level of security. They also would like to structure some of the children’s legacies to include future gifts to a favored charity.

To provide a basic level of security to the children during their years of retirement, they arrange that at the death of the second parent three gifts of $250,000 each be given to the charity in exchange for gift annuities. The annual annuity payments to each child will be $250,000 multiplied by the ACGA’s recommended rate for a person of the child’s age at the time of the surviving parent.

George dies one year after completing their estate plan and Linda seven years after completing the plan. At Linda’s death, Daniel is aged 69, Suzanne is 67, and Donald is 64. They receive, respectively, each year $14,500, $14,000, and $13,250. The ones who receive a lesser amount have a probability of receiving payments for a longer time because they are younger, so they are treated equally.

No matter what happens in the economy and no matter the outcome of their personal investments, they at least can count on a certain amount without any management responsibility. Moreover, the charity will receive the residuum of the contribution for all three annuities.

These are only a few of the instances when a testamentary gift annuity can help donors achieve their objectives.

Note: The gift annuity rates and the Sec. 7520 interest rate used in the examples are not necessarily the ones in effect at any particular time.

By Frank Minton

Last Updated on Monday, January 23, 2023 01:21 PM