Savings bonds and commercial annuities are considered by many to be very safe investments for individuals. Investors enjoy the guaranteed return these assets offer. Many individuals are concerned that they might outlive their nest eggs. Savings bonds and commercial annuities have been marketed as low-risk investments that can ease that fear.
Over the years, many individuals have invested in U.S. savings bonds or commercial annuities. Individuals who are charitably-minded may be interested in gifting savings bonds or commercial annuities to charity. This article will discuss the effects of making charitable gifts of savings bonds and commercial annuities, both during life and at death. Advisors will be able to help their clients understand the tax consequences of gifting savings bonds and commercial annuities. By gaining this understanding, advisors will be equipped to guide their clients through the gifting process and help fulfill their clients' goals and objectives.
U.S. savings bonds are issued by the Department of Treasury and backed by the full faith and credit of the U.S. government. Because of this guarantee, savings bonds are generally considered a stable investment. The trade-off for the safety that these investment vehicles provide is a smaller investment return. The guaranteed return for a Series EE savings bond hovers at approximately 3.5%, while the rate for the Series I savings bond starts at 2.52% for bonds issued in mid-2018. Those returns are much lower in comparison to stocks, which have averaged a return of approximately 7% over the past decade.
The two most common savings bonds are Series EE and Series I bonds. Series EE and Series I savings bonds are subject to the same rules and tax treatment, despite their differences in structure. When savings bonds reach final maturity, all accumulated interest income must be recognized in the year the savings bond matures.
Series EE bonds are purchased at a discounted value. A Series EE bond is sold for half its face value and will accrue interest at a fixed rate. Series EE bonds will mature to face value after 20 years. After the maturity date, Series EE bonds continue to accrue interest for an additional 10 year period until reaching the final maturity date. The accumulated interest will be taxed on the final maturity date 30 years after its purchase, if not cashed in prior to that date.
Series I bonds, on the other hand, accrue interest at a variable rate. A Series I bond accrues interest at a guaranteed fixed interest rate plus the variable inflation rate as calculated in semiannual intervals. The potential benefit of the variable rate is that it allows Series I bonds to potentially appreciate at a higher rate than Series EE bonds.
The variable rate also means that Series I bonds carry more risk than Series EE bonds. Series I bonds accrue interest for 30 years, but the savings bond is not guaranteed to double in value by the 30-year maturity date. Because the fixed interest rate is added to the inflation rate, Series I bonds bear a risk that there will be little or no appreciation if the inflation rate is negative. Series I bonds will never be worth less than their purchase price because the combined variable rate cannot fall below zero.
A commercial annuity is an agreement between a financial institution, such as an insurance company or a bank, and an annuitant. Commercial annuity contracts promise fixed or variable income payments from the financial institution for the duration of the annuitant's life or a term of years. Most annuity contracts also offer a death benefit. The annuity contract is backed by the assets of the insurance company or bank. Thus, it is important that the annuity is purchased from a strong and reliable company.
Annuities are often purchased by individuals as a means of insuring adequate retirement income and may be acquired as part of a retirement account or with after-tax income. Lifetime transfers of annuities purchased on or before April 22, 1987 require recognition of ordinary income when the annuitant receives proceeds from the contract in excess of the cost basis. For the purposes of this article, after-tax funds are assumed to have been used to purchase a deferred commercial annuity after April 22, 1987 that has not been annuitized.
Commercial annuities can be structured in a variety of ways. The annuity can provide a minimum guaranteed payout or minimum guaranteed duration. An annuity can begin making payments immediately or can defer payments for a number of years. A flexible payout option is also available.
Commercial annuities grow on a tax-deferred basis and there is no limit to the amount of money that can be used to fund the contract. If the annuitant is younger than 59½, there is a 10% penalty for withdrawing funds from the annuity. When the annuity starts making payments, the distributions are taxed as ordinary income with a portion designated as tax-free return of principal. Commercial annuities typically offer a reasonably high payout.
Commercial annuities should be distinguished from charitable gift annuities. A charitable gift annuity is a contract between a donor and a charitable organization that makes payments for one or two lives. When the charitable gift annuity ends, the charitable organization receives the use of the remaining contract value. With a commercial annuity, the entire funds, minus fees, will be invested and are expected to be returned to the annuitant through the annuity payments. In most cases, a death benefit to a designated beneficiary is an additional option.
Lifetime Transfers of Savings Bonds
Many individuals may have held savings bonds for quite some time and desire an increase in their investment return. Investors may wish to make lifetime gifts of those savings bonds to charity. The owner of the savings bonds hopes to receive a charitable income tax deduction and bypass the interest income held in the bond.
Savings bonds can only be registered in the name of an individual. See 31 C.F.R. 315.6. Charities cannot be listed as owners, co-owners or beneficiaries on savings bonds. Due to these restrictions on re-issuing savings bonds, lifetime gifts of savings bonds to charity can only be accomplished by redeeming the savings bond and making a cash donation of the proceeds.
In general, transfers of savings bonds prior to the final maturity date will accelerate the accumulated interest in the year of the transfer. Reg. 1.454-1(c)(1). Rev. Rul. 55-278. No exception exists for charitable donations of savings bonds during life. PLR 8010082. The owner will be required to recognize the interest income on the difference between the amount paid for the savings bond and the redemption value of the bond.
The tax consequences of recognizing interest income on the savings bond will be offset by the charitable income tax deduction generated from the cash donation of the proceeds. Since this is a cash gift, the donor will be able to use the deduction to offset up to 60% of his or her adjusted gross income. The donor can carry forward any remaining deduction for up to five additional years.
Judy purchased Series EE bonds approximately 25 years ago. Her bonds were five years from the final maturity date. Judy went to her bank to have her bonds transferred to the name of her favorite charity. The bank informed her that she cannot have the bonds re-issued to the charity. Instead, Judy decided to cash in her savings bonds. She was required to report the accumulated interest from the savings bonds on her income tax return. Judy received a charitable deduction for the cash proceeds she donated to her favorite charity. She may use her deduction to offset up to 60% of her adjusted gross income.
Lifetime Transfers of Commercial Annuities
Some individuals may find they have retirement security and do not need any additional income from a commercial annuity. Others may find that the return from the annuity is not as substantial as they hoped and decide to terminate the contract. Typically, individuals will want to avoid surrender charges for early terminations of an annuity contract. Many hope that making a gift of an annuity contract to charity will meet that goal and provide a charitable income tax deduction.
Generally, deferred commercial annuities may be transferred to charity. If the commercial annuity has been annuitized, the transfer options may be limited or not permitted. A commercial annuity is deemed annuitized if the annuity contract has been converted to a specified payment schedule. If the contract is transferrable, a charitable transfer will require the recognition of any untaxed gain in the year of the transfer. The tax consequences of the transfer may be offset at least in part by a charitable income tax deduction.
A commercial annuity is part investment, which is the amount the annuitant paid for the annuity, and part ordinary income, which is the amount of the tax-deferred earnings. A portion of the distribution will be recognized as ordinary income if the annuity is worth more than the original cost. The original cost of the annuity will be distributed tax free, but any amount in excess will be taxed as ordinary income. Therefore, a donor will recognize and be required to report any untaxed gain as ordinary income in the year that the transfer is made. The ordinary income would be equal to the difference between the surrender value of the commercial annuity and the donor's basis in the annuity. The donation of the annuity contract to charity may avoid surrender charges if the annuity is outside the surrender period.
The donor will receive a charitable deduction for the value of the annuity contract. If the annuity contract is over $5,000 in value, the donor will be required to obtain a qualified appraisal. Although the annuity contract may have a value assigned to it through the issuing organization, the IRS requires a qualified appraisal for all non-cash charitable gifts valued at more than $5,000. The donation of an annuity contract would be subject to a deduction limit of 50% of the donor's adjusted gross income, as it is a cost basis deduction. Donors rarely, if ever, structure their gift in this way.
In almost all circumstances, a donor will surrender the annuity contract and donate the cash received. If the donor makes the gift using the cash proceeds from the contract surrender, he or she would be entitled to a deduction of up to 60% of adjusted gross income. Although the tax consequences remain the same, the difference between the surrender value and the purchase price will be taxed as ordinary income in the year of the transfer, the charitable deduction may be more attractive because the deduction limit increases to 60% for cash gifts. An annuitant may be more inclined to donate the cash proceeds from the surrender of the annuity contract.
Xavier wanted to make a gift using his commercial annuity contract to his favorite charity. Xavier's insurance company confirmed that he was outside his surrender period. Xavier decided to surrender his commercial annuity to the insurance company in order to make a cash gift to his favorite charity. His annuity was valued at $100,000, with a cash value of $75,000. Xavier's original cost for the annuity was $50,000. He recognizes $25,000 as ordinary income. Xavier's adjusted gross income for the year was $125,000. His charitable deduction was limited to 60% of his adjusted gross income, since this was a cash gift. He was able to use all $75,000 of his charitable deduction in the year of the gift.
Generally, charitably-minded owners of commercial annuities hope to avoid generating additional taxable income and want to benefit from charitable income tax deductions. The taxability of lifetime transfers of savings bonds and commercial annuities may dissuade some of these donors from making lifetime charitable transfers. The tax treatment of lifetime transfers to charity is not dependent on whether the gift is made outright or through a life income gift, such as a charitable remainder trust or a charitable gift annuity. The charitable income tax deduction resulting from the gift can be used to offset the ordinary income recognized from the transfer. There may be additional options to explore when using savings bonds or commercial annuities to meet a donor's philanthropic goals.
Testamentary Transfers of Income in Respect of a Decedent Assets
Commercial annuities and savings bonds are assets categorized as income in respect of a decedent ("IRD"). IRD refers to the amounts that a decedent was entitled to as gross income, but was not received nor taxed as the decedent's income prior to the decedent's death. IRD assets represent untaxed ordinary income and are governed by Sec. 691. IRD assets are included in the estate of the decedent and may be subject to estate tax. Under Sec. 691(c), there is an offsetting deduction for estate tax paid on IRD assets.
Some common examples of IRD assets include IRAs, U.S. savings bonds and commercial annuities. Generally, IRD assets are known as "bad assets" to pass on to heirs due to their tax consequences. IRD assets are subject to tax at ordinary income rates on all distributions. Other appreciated assets, such as stocks and real estate, receive a stepped-up basis upon the original owner's death and are considered "good assets," because they can be sold by the beneficiary without paying a large capital gain tax.
Many financial planners suggest transferring "bad assets" to qualified charities and "good assets" to heirs. This transfer at death provides a two-fold benefit. The charity can sell IRD assets tax free and heirs will avoid the negative IRD tax consequences, while receiving a generous inheritance from other assets in the estate.
Transfers at death, known as testamentary transfers, of savings bonds and commercial annuities to heirs may result in the assets being subject to two tiers of taxation. Typically, IRD assets are included in the decedent's estate for estate tax purposes and distributions to heirs will be subject to income tax. Testamentary charitable gifts of savings bonds and commercial annuities may provide a more favorable outcome. Most estates will not be subject to the estate tax because the lifetime exemption shields estates up to $11.18 million per decedent in 2018, with indexed increases thereafter and a sunset provision in 2025. Charitable solutions can alleviate some of the tax burdens associated with IRD assets and advisors can better serve their clients by understanding the challenges associated with these assets.
Testamentary Transfers of Savings Bonds
The regulations restricting the re-issue of savings bonds will prohibit a charity from being named as a co-owner of the savings bonds. If an individual wants to use a savings bond to benefit his or her favorite charity at death, the best option is to leave a specific bequest of the savings bonds to charity in a will or trust. If a specific bequest of the savings bonds is not included in the estate plan, there are two possible outcomes. If there is no will or trust directive to use IRD assets to fulfill charitable bequests, the estate may be required to recognize the interest income held within the bonds. As a result, the estate would be required to realize ordinary income before the proceeds are passed on to charity. The reduced after tax amount would pass to charity.
Alternatively, if the executor or trustee has the authority under local law to make non-pro rata or in-kind allocations, the estate may be able to avoid tax on the savings bonds. PLR 9537011. If local law is silent on the matter, the estate document may specifically provide that the savings bonds can be used to satisfy charitable gifts from the estate and the estate will avoid income taxation on the interest accumulated in the bond. If savings bonds are used to satisfy pecuniary bequests or bequests of specific dollar amounts, savings bonds may be subject to income tax within the estate. PLR 9507008.
If a qualified charity receives savings bonds, it may be able to redeem the bonds tax free. If the savings bonds were not subject to income tax at the estate level, they will escape taxation completely because the charity will not be taxed on the redemption. Savings bonds will avoid income tax at the estate level if the testamentary transfer was either a specific bequest of the savings bonds or there is authorization under local law that permits the executor to satisfy charitable bequests with IRD assets. The estate will avoid the estate tax on the savings bonds and the charity is exempt from taxation. This is a great result for the estate and the charity.
Linda was the executor of her mother's estate. Her mother left the residue of her estate to charity in her will. The will provided that IRD assets were to be used to satisfy charitable gifts. Linda used the savings bonds to satisfy the charitable bequest. The estate avoided paying estate tax and the heirs avoided income tax on the savings bonds. The charity did not owe income tax on the savings bond received and was able to use the entire value for its charitable purpose.
Testamentary Transfers of Commercial Annuities
In some instances, a commercial annuity may offer a death benefit to a beneficiary of the annuitant's choice. If an annuity has already been annuitized, a testamentary transfer may be the only option for a gift to charity. A commercial annuity is generally not controlled by an estate planning document. The annuity administrator will distribute the death benefit according to the beneficiary designation form.
A beneficiary designation form is the controlling document that dictates how the account is distributed after the accountholder's death. The beneficiary designation form can be obtained from the account administrator or custodian. It is a fairly simple and easy way to change the beneficiary on an account.
The owner may designate a primary beneficiary, a contingent beneficiary or split percentage beneficiaries. Generally, distributions from the annuity contract will be subject to income taxation. The heir may choose a lump sum, a five-year payout or to annuitize the payout. Heirs will be subject to income tax on the annuity proceeds regardless of the payout chosen.
A charity may be listed as a designated beneficiary of a commercial annuity. If a qualified charity is the beneficiary on the beneficiary designation form, any distribution received from the commercial annuity will be estate and income tax free. The charity will be free to use the entire proceeds for its charitable purposes.
Edward listed his favorite charity as the designated beneficiary of his commercial annuity. His annuity contract offered substantial death benefits for his beneficiary. Later in life, Edward created a will. The will stated that his entire estate was to be given to his niece Elizabeth. When Edward passed away, the commercial annuity was distributed according to the beneficiary designation form he completed, not according to his will. Edward's favorite charity received the proceeds from his commercial annuity and Elizabeth received the other assets from her uncle's estate.
Transfers of savings bonds and commercial annuities generally have similar tax treatment. Outright gifts to charity have the same tax deduction limits as gifts to fund charitable gift annuities or charitable remainder trusts. The unrealized ordinary income will be recognized at the time of transfer. Lifetime transfers of cash proceeds from savings bonds or commercial annuities may generate large charitable deductions, which can be used to offset the tax consequences of the transfer.
Testamentary transfers may be more attractive to donors. If the gift is structured correctly, the asset will avoid estate and income tax. The charity is able to cash in the asset tax free, as well. The estate will receive an estate tax deduction, however, most estates will not reach the threshold for taxation. A testamentary transfer to charity will allow heirs to avoid recognizing taxable income from the IRD asset and allow the entire proceeds to be gifted to charity.
Individuals may have commercial annuities or savings bonds that have been held for many years and may be interested in using those low-yield assets to make gifts to charity. By understanding the options and strategies that are available for transferring these low-yield investments, advisors can better serve their clients and provide creative solutions that will benefit the client and achieve their personal and financial objectives.