Another method involves donating an existing policy to a charity during the donor’s lifetime. While more complex from a tax perspective, this strategy can provide immediate and ongoing tax benefits. This post focuses on this method.

An Example: Donation of an Existing Policy

To illustrate, consider an example of Clara, who owns a $1 million permanent life insurance policy initially purchased for estate planning purposes, which are no longer relevant. The policy has a cash surrender value (CSV) of $130,000 and an adjusted cost basis (ACB) of $90,000. If Clara were to surrender the policy, she would face a taxable gain of $40,000 (CSV minus ACB). Assuming a 50% tax rate, her tax liability would be $20,000, leaving her with net proceeds of $110,000. Before surrendering the policy, Clara consults her insurance advisor, who suggests she consider donating the policy to her favorite charity. After agreeing, the charity accepts the policy and has it appraised by a qualified actuary. Considering Clara’s health, the policy’s death benefit, future interest rates, and other factors, the actuary determines the policy’s fair market value (FMV) to be $420,000. Clara proceeds with the donation, and the charity issues a donation receipt for $420,000. The tax savings from this donation approximate $210,000 (depending on Clara’s province of residence), significantly outweighing the $20,000 tax payable on the policy disposition. Clara’s proceeds of disposition are equal to the policy’s CSV of $130,000, the same as if she had surrendered it. The donation credit can be used to offset tax in the year of donation, up to 75% of Clara’s net income, with any excess carried forward for up to five years.

Important Considerations for Donors

1. Ownership Period Rules: If a donor has owned the policy for less than three years (or less than ten years if acquired with the intention of donation), the value of the gift is limited to the lesser of its FMV or its ACB. For example, if Clara had owned the policy for just two years, the donation value would be restricted to its ACB of $90,000, reducing the potential tax benefits.
2. Term-to-Permanent Policy Conversion: A policy converted from term to permanent shortly before donation may be treated as a new policy under the three- and ten-year rules, limiting the donation value to the ACB. A cautious approach, such as gifting the term policy before conversion, may avoid this issue.
3. Charity’s Willingness to Accept: Not all charities are equipped to manage ongoing premium payments or other complexities associated with owning a life insurance policy. Donors should discuss these details with the intended charity early in the process. Larger charities or public foundations may be better suited to accept such gifts.

Final Thoughts

Donating a life insurance policy can be a win-win for donors and charities, providing significant tax relief while supporting meaningful causes. However, the strategy requires careful planning and professional advice to navigate tax rules and maximize benefits. Prospective donors should work closely with qualified tax and actuarial advisors, as well as the chosen charity, to ensure a smooth and mutually beneficial process.