It’s not often in life that we come across a true win-win opportunity. The Charitable Gift Annuity is one such strategy.

The Charitable Gift Annuity strategy is a tax effective method for a retiree to provide a significant donation to a charity and receive a larger guaranteed after-tax income in the process. Further, the donor does not need to manage the investments.  New rules unfortunately dictate that this strategy may soon lose some of its appeal, creating a bit of a buying opportunity at the same time.

For financial advisors, the February 2014 Federal Budget was widely perceived as a stay-the-course document as compared to the prior one in 2013, which in many ways was a watershed moment for the financial services industry and the life insurance sector in particular. Higher profile changes in the 2014 Budget, like modifications to the dividend tax regime, the elimination of leveraged insured annuities and 10-8 life insurance arrangements, along with the future eradication of graduated tax rates for testamentary trusts, garnered most of the publicity. However, upcoming changes to the insurance policy tax sheltering Maximum Tax Actuarial Reserve (MTAR) rules will likely have the more pronounced, long term impact on the industry. As a consequence, the 2014 Budget will also have an adverse effect on the Charitable Gift Annuity strategy. The good news is with the changes scheduled for implementation in 2016, advisors and their clients who can benefit from this creative donation strategy have an almost two year window (from the date of this writing) to take advantage of the existing rules.

The Income Tax Act contains rules regarding the taxation of the income earned on the savings inside a life insurance policy. An exempt test is applied each year to determine whether the policy can avoid tax on an accrual basis at the policyholder level. If not, the income is subject to a 15% IIT (Investment Income Tax) that is levied on the insurer. What is not widely known, however, is that the MTAR rule proposals for change would also impact the determination of the capital element of annuity payments for certain annuity contracts.

In clause 2 of the explanatory notes of the life insurance policy exemption test, Paragraph 300(2)(a) of the Income Tax Act has been proposed to be amended to update the mortality tables used in determining the payments expected to be made under a life annuity contract. As a result of the use of the new tables, since life expectancy has increased, the “taxable” portion of a prescribed annuity will be higher and the capital element of the annuity correspondingly reduced, resulting in a lower “net” after tax income for the annuitant in the earlier years of the annuity payments. While this change has considerable retirement planning implications, it will also have a bearing on the current overall benefits of the Charitable Gift Annuity strategy.

As the strategy applies today, historically low interest rates have limited the amount of income retirees can derive from low risk, fixed income investments such as GICs and bonds. To compound the problem, interest is fully taxed as opposed to other investments like dividends and capital gains. This situation has left many retirees who are looking for a guaranteed income stream (without being forced to encroach on their capital) in a bit of a quandary. As well, since many retirees have the desire to be more charitable, the reduced income and cash flow has limited the amount they have available to fulfil their philanthropic wishes.

It is precisely in this type of scenario that the Charitable Gift Annuity strategy can be so beneficial. The process involves a charity facilitating the buying of an annuity from an insurance company on behalf of a donor. The charity generally retains 25% to 50% of the donation, while using the balance to purchase an annuity providing the donor with set payments for life. The donor receives a guaranteed income each year, much of it tax-free based on current rules which deem some part of the annuity payments to be a return of capital. The donor also receives a tax receipt for the amount retained by the charity.

This type of arrangement is most advantageous for donors aged 70 and over. Couples may prefer a “joint and last survivor” annuity which would provide payments until both individuals have died.

The best part is that the income is greater than what the donor would have earned in a similar sum invested in a GIC.

As an example, Mr. and Mrs. Cohen, ages 81 and 74 respectively, currently have a $40,000 GIC with interest at 2.5% coming up for renewal in a non-registered account. The income payable from the GIC would be $1,000 per year, but after tax only nets them $540 (assuming their incomes are between approximately $135,000 and $509,000 each in 2013). Their financial advisor recommends the Charitable Gift Annuity Strategy, whereby the couple buys a joint annuity with half the proceeds and donates the other half to the Jewish Foundation of Greater Toronto, setting up a Donor Advised Fund in the process. The couple is delighted to find out that not only did they provide a substantial gift to the Foundation, but also their net after tax income almost triples to $1,455 annually compared to the GIC, amounting to a 13.5% pre-tax equivalent rate of return. They receive a tax receipt for the $20,000 donated amount, which provides even further tax savings for the year.

GICs assume 2.5% interest rate
Marginal tax rate 46.4%

Given the upcoming changes to the taxable portion of annuities starting in 2016, advisors and their clients interested in taking advantage of this strategy have an even more compelling reason to do so while the current regime is still in effect.

Eric is a member of the Jewish Foundation of Greater Toronto’s Professional Advisory Committee (PAC). He can be reached at eric.benchetrit@sympatico.ca for further discussion.