In order to test my impression, I applied the principles of discounted cash flow analysis that I have used myself and taught professionally for many years in my courses on investment evaluation. I analyzed two options. Under the first option, we would sell our stock and reinvest it in an investment grade corporate bond. Under the second, we would donate our stock to establish a charitable gift annuity and receive fixed payments from the annuity so long as either of us survived. All calculations were made on an after-tax basis, taking into account the effect of income taxes, capital gains taxes, and estate taxes. Then, I calculated the “present worth” of the after-tax cash flows that we could reasonably expect from each option. These figures provided a concrete basis for making a financial comparison. The charitable gift annuity actually yielded a larger present worth than selling the stock and reinvesting in bonds. As a result, we have since established two gift annuities with Mines.

Sample Analysis

Let’s briefly illustrate this kind of financial analysis by applying it to two individuals. Mr. and Mrs. Smith, both of whom are 70 years old, own stock that they would like to reinvest. It originally cost them only $40,000 and now has a market value of $100,000. Let’s also make the following assumptions:

•    The Smiths’ applicable income tax rate is 40% (35% federal plus 5% state).
•    Their applicable capital gains tax rate is 20% (15% federal plus 5% state).
•    Their property will be subject to federal estate tax of 45% at their death.
•    They will live to their joint life expectancy, which is 20 years.

Mr. and Mrs. Smith are considering two options. The first is to sell the stock and purchase a corporate bond that will pay 6% interest each year. The second option is to donate the stock to establish a charitable gift annuity. Based on their ages at the date of gift, the annuity will make fixed payments of 5.9% each year so long as either of them survives.

Option 1: Sell stock and reinvest in 6% bond

If the Smiths sell their stock, they will have to pay $12,000 in capital gains taxes, leaving only $88,000 to reinvest. The bond pays a nominal rate of 6%, yielding annual pretax income of $5,280. However, the Smiths’ income tax rate is 40%, making the bond’s after-tax rate only 3.6%. Applying this rate to the $88,000 investment, we find that the Smiths will receive after-tax income of $3,168 each year.

When the bond matures in 20 years, the Smiths will be repaid their $88,000. However, along with the rest of their estate, this principal will be subject to federal estate tax of 45%, leaving an after-tax maturity value of only $48,400. We can summarize as follows:

Next we calculate the “present worth” of the cash flows that the Smiths will receive. Present worth calculations are based on the principle that it’s more valuable to receive a dollar today than to receive it in the future. The longer you have to wait for that dollar, the less valuable it is.

When we calculate the present worth of the interest payments and maturity value on the bond, we are assigning a current value to the payments that the Smiths are entitled to receive over the next twenty years. This value can be derived by using three factors: the number of years (n = 20); the applicable interest rate (i = 3.6%); and the timing and size of payments (annual payments of $3,168 and one large payment of $48,400 at the end of twenty years). In general, the higher the present worth, the more desirable the investment option.

Option 2: Donate stock to establish 5.9% gift annuity

If the Smiths transfer their stock to a charity to establish a gift annuity, no capital gains taxes will be due on the transfer. They will receive fixed payments of $5,900 each year. Of this amount, $2,207 will be taxed at their income tax rate of 40%. Another $2,216 will be taxed at the lower capital gains rate of 20%. The remaining $1,477 will be tax-free. The Smiths will also be entitled to a charitable deduction of $24,277 to apply against their taxable income in the year they make the gift. We can summarize the after-tax cash flows from the annuity as follows:

Thus the Smiths will receive annual after-tax payments of $4,574 and an income tax savings of $9,711 in the year they make the gift. Because any remaining principal goes to charity at their death, no estate taxes will be assessed. We can calculate the present worth of these cash flows using the same factors that we used in the previous present worth calculation—a period of twenty years, an interest rate of 3.6%, and annual payments of $4,574:

Although the Smiths are making a generous charitable gift, the present worth of establishing the gift annuity option is actually somewhat higher than selling and reinvesting.

What about using cash instead of securities?

It’s interesting to note that the same result applies if the Smiths choose to invest cash rather than appreciated securities. Holding our other assumptions constant, our analysis shows that a $100,000 cash investment in the bond yields a present worth of $77,817. Using cash to establish a gift annuity yields a present worth of $80,374. Under this scenario, more than 60% of the Smiths’ annuity payments will be tax-free.

It’s important to bear in mind that your initial contribution to a gift annuity is irrevocable. Once the annuity is established, you have no access to gift principal. Accordingly, you should be comfortable with the idea of putting this money out of reach in order to make your gift and receive the benefits associated with it.

It’s also important to remember that this analysis is based on a number of assumptions. Benefits will vary depending on your own situation. Also, current conditions may change—as the uncertainty surrounding the future status of the estate tax illustrates. In order to obtain an estimate of benefits based on your own circumstances, please consult with the planned giving staff in Mines’ Office of Institutional Advancement.

I hope that this brief illustration demonstrates that it is possible to combine philanthropy with fiscal prudence. By establishing an annuity or other gift plan, you are not necessarily “giving away” the family estate. On the contrary, you may find yourself better able to help your loved ones now—for example, by assisting grandchildren with college tuition. The best thing is, you’ll still be around to experience the joy of giving.

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