Do you own too much of a good thing?
One of the keys to successful long-term investing is diversification – owning enough of different kinds of investments so that your entire portfolio doesn’t move in the same direction (up or down) at the same time.
Sometimes, whether through inheritance, a long-ago purchase, or sale of a business, some investors may find themselves holding a single stock that makes up a substantial portion of their overall portfolio – known as a concentrated position. Generally, holding a concentrated position is not wise.
If that stock is held in a taxable account, and it has appreciated significantly since first acquired, the tax alone might be enough to keep an investor from selling the stock, even though selling and diversifying would be in the best interest of the investor and would reduce the risk in the portfolio.
Another objection to selling: the investor is relying on the dividends from that stock for income.
Fortunately, charitable strategies can be employed to allow an investor to sell a concentrated position, defer the capital gains tax that would otherwise be due on the sale, generate income, and receive a charitable deduction, all in one fell swoop.
This week we will look at the first of two solutions to the dilemma of the concentrated position: the charitable gift annuity.
What is a Charitable Gift Annuity?
A charitable gift annuity (“CGA” for short) is a contractual arrangement between a donor and a charity whereby the donor gives cash, securities, or other assets to the charity in exchange for the payment of income for life.
The amount of annuity income paid by the charity is dependent on the age of the donor – the older the donor, the more income gets paid. Most charities use a standard table of annuity rates published by the American Council on Gift Annuities and updated regularly.
Case Study – Charitable Gift Annuity
Here’s how the CGA can be used to diversify a concentrated position:
Assume Jane Donor, age 75, owns 1,000 shares of Company X that she bought at $10 per share many years ago. Shares are now selling for $200 – a $190/share profit. Jane’s portfolio, valued at $2 million, consists of a broad range of mutual funds, but she holds Company X because she doesn’t want to pay the tax on the gain. Company X makes up 10% of her portfolio – a concentrated position. Company X’s dividend yield is 2%.
Jane decides to establish a charitable gift annuity with her alma mater, and fund the annuity with her Company X shares. She delivers the shares electronically to her alma mater’s brokerage account – her portfolio is now worth just $1.8 million, but she no longer has a concentrated position.
At age 75, Jane’s published gift annuity rate is 5.8%, meaning her alma mater will pay her $200,000 x 5.8% = $11,600 per year income for life – more than she was receiving from the Company X dividend.
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With a CGA, capital gains that would normally have been due upon the sale of a security are paid out in installments over the life expectancy of the donor. In this case, roughly $8,300 of each annual payment is taxed at favored capital gains rates for the next 12 years. The remainder of the income payment is part ordinary income and part tax-free return of principal.
Jane also gets a charitable deduction of $91,543 (assumes 2.4% AFR) which she can use to offset her income this year. To the extent that she can’t absorb the entire deduction, the unused amount gets carried forward for up to five additional years.
And, Jane gets to make a major gift to her alma mater, which keeps whatever amount remains from the original gift after Jane passes away.
This is the only drawback to the CGA, from the donor’s perspective: if the donor passes away early during the annuity period, the annuity ends and the charity “wins.” CGAs can be established to benefit a husband and wife for their joint life expectancy, but the joint annuity rates will be lower than those for a single individual.
Consider a charitable gift annuity to help diversify a concentrated position if:
- You are charitably inclined;
- You are at least 60 years old (most charities who offer CGAs have minimum age requirements);
- You want a simple, hassle-free way of achieving greater diversification in your portfolio;
- You are relying on income from the concentrated position.
Next week we will look at a more advanced solution to the concentrated position that offers greater flexibility: the charitable remainder trust.