Turbocharge Your Charitable Gifts by Donating Your Life Insurance Policy
Make Larger Donations Later, Get Tax Benefits Now
If philanthropy is one of your goals, donating your life insurance policy to charity can be a powerful strategy. It allows you to make larger gifts than you might otherwise afford, while generating current tax benefits.
Whether this strategy is right for you depends on your specific circumstances and your family’s financial situation. It is also important to understand the tax implications of a charitable gift of life insurance.
Life Insurance is a Versatile Financial Tool
Life insurance can be a versatile financial planning tool. It provides a significant source of wealth for a relatively modest investment and creates instant liquidity your family can use to pay any applicable estate taxes or other expenses.
Building Cash Values on Tax-Deferred Basis
In addition to death benefits, permanent life insurance policies allow you to build substantial cash values on a tax-deferred basis. You can withdraw or borrow against these funds to provide a source of retirement income or to meet other needs (keeping in mind that this may reduce the cash value as well as the death benefit paid to your beneficiaries).
Have you reached a point in your life where you no longer need life insurance? Perhaps your children are financially independent and your IRAs, 401(k)s or other savings are more than sufficient to meet your retirement needs. Under these circumstances, donating life insurance to charity may be an attractive option.
Examples How to Use Life Insurance for Charitable Gifts
Consider Phil, for example. He is a 60-year-old widower with two children, both of whom are finished with college and gainfully employed. He has substantial savings in an IRA and his company’s retirement plan, but continues to pay premiums of $10,000 per year on a $1 million life insurance policy. The policy’s cash surrender value is $400,000, and Phil’s cost basis in the policy, based on premiums paid, is $200,000. If he simply surrenders the policy in exchange for its cash value, he will recognize $200,000 in ordinary income.
In a meeting with his financial advisor, Phil expresses an interest in giving more to charity. The advisor explains how Phil can accomplish this goal, while actually improving his cash flow, by donating his life insurance policy. Phil would enjoy a charitable income tax deduction for the initial donation as well as for any premiums he pays in the future. And when Phil dies, the charity would receive a $1 million gift.
The most tax-effective way to donate life insurance is to transfer the policy so that the charity becomes the owner and beneficiary. You are entitled to an immediate charitable deduction for income tax purposes. If you continue to pay the premiums, each payment is also a deductible charitable donation.
In addition, the policy is removed from your estate, which can mean significant estate tax savings. (Even though, as of this writing, an estate tax repeal is in effect for 2010, the estate tax is scheduled to return in 2011. Plus the repeal may be repealed.)
Tax-deducts Based on Fair Market Value
You may be surprised to learn that you can not necessarily deduct the policy’s face value or cash surrender value; rather, the deduction is limited to the policy’s fair market value or your cost basis, whichever is less. Determining a policy’s fair market value is complex, requiring consideration of factors such as the policy’s cash surrender value, the cost of purchasing a comparable policy and the insurer’s actuarially calculated reserves.
Cost basis generally means the total amount of premiums you have paid on the policy (less any dividends received). In our previous example, assuming that the policy’s fair market value is roughly equal to its cash surrender value, Phil would be entitled to a $200,000 charitable deduction.
Income tax charitable deductions for donated life insurance policies (as well as future premium payments) generally are limited to 50% of your adjusted gross income (30% for gifts to a nonoperating private foundation), though excess deductions can be carried forward for up to five years. Deductions for noncash gifts in excess of $5,000 must also be supported by a qualified appraisal.
There are several other life insurance strategies that can help you satisfy your philanthropic desires while preserving some benefits for yourself. See the sidebar “Other options” for more information.
Review your Finances
Donating a life insurance policy to charity can be a smart move under the right circumstances. By working with tax advisors to review your family’s financial situation, you can determine whether your needs would be best served by a charitable donation.
Other Ways to Donate your Life Insurance Policy
Donating a life insurance policy to charity outright is just one potential strategy for leveraging unneeded life insurance to achieve your philanthropic goals. Others include:
Charitable gift annuities. Exchanging a life insurance policy for a charitable gift annuity allows you to deduct the value of the benefit received by the charity while retaining an income stream for the rest of your life. Typically, the annuity payments consist of a combination of ordinary income and tax-free return of basis.
Wealth replacement. You can use other assets to make charitable gifts and to hold on to the life insurance policy to replace that wealth. By using other assets to fund a charitable remainder trust or similar vehicle, you can generate current income to pay the insurance premiums or for other purposes.