Charitable Leverage: A New Paradigm for Life Insurance and Charitable Remainder Trusts

Posted: Nov 18, 2010 11:41 AM

Ok, I confess, I’ve had a 32 year love affair with cash value life insurance. It is, in my view, the single most dynamic financial tool ever offered to the American consumer. But I’ve never been as excited about it as when I use it in my charitable leverage strategy. For philanthropically minded clients, a properly designed cash value life insurance policy (CVLI) married to a charitable remainder trust (CRT) can generate powerful and meaningful results. But here’s the twist, most financial advisors I talk to focus on the traditional, estate planning use of the CRT and Insurance. You know the one; the two-life unitrust with life insurance in the role of wealth replacement. In my version, however, we’re going to change the paradigm from estate planning tool to a retirement planning one.

First, we need to establish what I mean by the word “leverage.” I do not use it in the financial sense. There are no loans or premium financing involved. Rather, I use it in the physical sense. If you understand how a screwdriver works, you’ll pretty much grasp this program. If you try to turn a screw with your fingers, you’ll only get so far. Use the simple lever of a screwdriver and you achieve exceptional results. In a charitably leveraged strategy, the lever is the CRT and the object it acts upon (the screw if you will) is the CVLI policy. Like the physical leverage example, the results are remarkable.

The Lever:

A key element to the success of this strategy is to keep it simple, and CRTs are not. However, when we use a “term of years” Charitable Remainder Annuity Trust(CRAT) we can remove a lot of the moving parts. I like to use a 10 year CRAT with an 8% fixed annuity distribution. Use of a term of years trust eliminates a “tax-deduction based on age” calculation; while the fixed annuity eliminates guessing on the income stream. Everyone at any age will get the same tax deduction and receive the same amount of income over the same length of time. How’s that for simple?

For example, a $500,000 deposit to the CRAT above will generate a $170,000 charitable income tax deduction in the first year (assuming a 4% AFR), and pay out $40,000 each year for ten years ($400,000 total). At the end of the tenth year, whatever remains in the CRAT is distributed to the donor’s favorite charities or Donor Advised Fund. If the CRAT investments earned 5% annually over the ten years, while distributing $40,000 per year, it would have a remaining balance of about $311,000 that would be given to charity at the end of the term.

The Object

I stated earlier that I loved a good CVLI policy. What I really love about it is the living benefits it provides while wrapped in the security of a pre-retirement death benefit. In our charitably leveraged strategy, I reduce the death benefit to the TAMRA plus cash value minimum during the “accumulation phase,” which is the time between year one and the first year of desired deferred income. This design will achieve the greatest amount of cash value growth. I like to use an equity indexed UL or VUL policy because the owner will be attracted to returns linked to market conditions. However, a growth oriented whole life policy will work just fine. The only must is the inclusion of an “over-loan” or similarly named 2 lapse prevention feature, since we will be drawing down the cash value in the “retirement” years and we want to avoid a taxable event created by a policy lapse.

For example, listed below are the projected results for a male age 45 preferred non-smoker, who pays $40,000 annual premium for ten years to an Equity Indexed UL policy from a top rated carrier, assuming a 6% gross return:

• The initial death benefit would be $874,000 plus cash value

• $60,000 annual cash-flow from the policy from age 66 to 85 (20 years)

• $1,200,000 total cash-flow from the policy

• $349,000 remaining death benefit at age 86

• Obviously these projections are for educational purposes only and are not guaranteed. A change in the assumptions will alter the outcome.

The Combination:

Charitable Leverage is created when the donor writes a single check or makes a single transfer of appreciated stock to the CRAT and then relaxes while it does all the heavy lifting.

1. The transfer creates a current charitable tax deduction.

2. Any sales of appreciated stock will avoid capital gains tax.

3. The annuity payment is fixed for ten years.

4. The fixed payment is used to fund the annual premium on the CVLI policy.

5. At the end of the tenth year, the CRAT terminates and is distributed to charity or Donor Advised Fund). If a Donor Advised Fund is used, it will continue making annual grants at the direction of the donor.

6. Whenever the owner of the CVLI policy elects, he or she can begin to take withdrawals and/or loans from the policy.

7. At the death of the insured, the remaining death benefit is paid to the heirs.

Using our $500,000 example and our prior assumptions (let’s also assume that we fund the trust with cash), here’s what charitable leverage would achieve.

• A tax deduction of $170,000.

• A future charitable gift of $311,000.

• Potential annual grants from the donor advised fund starting in year 11 of $15,550.

• Pre-retirement death benefit of $874,000 plus cash value.

• Total retirement income of $1,200,000 ($60,000/yr from age 66 to 85).

• Post retirement death benefit of $349,000.

• Remember this is an educational exercise and the projections are not guaranteed.

The combination of a term CRAT with a maximum funded CVLI policy creates something new and exciting to explore with folks who may wish to include philanthropy in their retirement plans in lieu of projected higher taxes. The new paradigm opens the door to myriad planning opportunities. This is not a do-it-yourself strategy. I am not an attorney or an accountant and I don’t provide legal or tax 3 advice. If anything I said here makes you want to take a closer look, please talk with a qualified legal or tax professional.