Insight on Estate Planning - February/March 2013: Should you donate life insurance to charity?

by Adler Pollock & Sheehan P.C.
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For the philanthropic minded, donating a life insurance policy to a favorite charity should rank high on their list of possible giving strategies. Why? Because doing so is an excellent opportunity to make a larger donation than may otherwise be affordable.

However, donating life insurance isn’t right for everyone. If, for example, your family’s financial security after you’re gone might depend on the policy’s payout, donating it won’t be a viable idea, even if it does allow for a larger donation. In addition, there are tax implications to consider.

An attractive option

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) plans 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.

Consider Clare, for example. She’s a 65-year-old widow with two children, both of whom are financially successful. She has substantial savings in an IRA and her 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 Clare’s cost basis in the policy, based on premiums paid, is $250,000. If she simply surrenders the policy in exchange for its cash value, she’ll recognize $150,000 in ordinary income.

In a meeting with her financial advisor, Clare expresses an interest in giving more to charity. The advisor explains how Clare can accomplish this goal — and improve her cash flow — by donating her life insurance policy. Clare would enjoy a charitable income tax deduction for the initial donation as well as for any premiums she pays in the future. And when Clare dies, the charity would receive a $1 million gift.

The tax impact

The most tax-effective way to donate life insurance is to transfer the policy so that the charity becomes the owner and beneficiary. You’ll generally be 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 taxable estate, which can mean significant estate tax savings.

You may be surprised to learn that you can’t 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’ve 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, Clare would be entitled to a $250,000 charitable deduction.

Consider your family first

If you have a charity that’s near and dear to your heart, donating a life insurance policy to it can be rewarding. But before taking action, discuss with your estate planning advisor your goals and your family’s financial situation. He or she can help you determine whether you can donate the policy while still providing for your loved ones to the extent you desire.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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