The discount rate used to determine the charitable deduction for various split interest gifts fell to 1.8 percent in December, a historic low.
Read on to learn how the discount rate is determined and how the current rate may affect which charitable gifts will be most appealing to donors in coming months.
Q: What does the term discount rate mean?
A: There are several types of discount rates. One is the interest rate that the Federal Reserve charges banks. This rate effectively provides a floor for interest rates. A discount rate is also the interest rate used to determine the present value, or time value, of money. For charitable gift calculation purposes, the applicable discount rate is pegged to a specific set of government interest rates.
Q: Where did the federal discount rate come from and how is it used in the gift planning arena?
A: Until the late 1980s, the federal government published tables that utilized a fixed discount rate for gift calculation purposes. The fact that the rate was artificially fixed made it possible to take advantage of periodic interest rate fluctuations when planning charitable gifts. In 1989, however, a switch was made to a floating discount rate based upon 120 percent of the applicable federal midterm rate (AFMR), the rate of interest the government pays on intermediate term debt obligations. Today, as a result, the discount rate used in the charitable gift calculation process changes monthly and, with the exception of pooled income fund calculations, a donor may elect to use the current month’s discount rate or the rate from either of the two previous months.
Q: How do fluctuations in the discount rate affect split interest gifts?
A: Various gift options are affected in different ways. For example, lower discount rates make charitable lead trusts and gifts of remainder interests in homes more attractive (read about an example on page 3). A higher discount rate would, on the other hand, increase the size of the charitable deduction for other types of gifts such as gift annuities and charitable remainder annuity trusts. Gift planners who understand the interplay of fluctuating interest rates on donors and gift plans may thus be more effective than others in the new year.
Q: Does the discount rate really fluctuate enough to make a difference?
A: The rate has fluctuated dramatically over the years, ranging from a high of 11.6 percent in 1989 to December’s historic low of 1.8 percent. Consider the impact on the amount that donors may deduct for identical gifts made to a charity over the course of time. Under an 11.6 percent discount rate, the charitable gift tax deduction for a $1 million charitable lead trust paying 6 percent for 20 years is $459,000. If a 1.8 percent discount rate is used, the deduction is $1 million, not an insignificant difference.
Q: Are there other gift planning considerations related to the discount rate?
A: Yes. Low discount rates can cause some gifts to fail the tests that ensure that at least 10 percent of the corpus will remain and that there is less than a 5 percent probability that the corpus will be exhausted by the end of the payout period. This applies to plans with a fixed payout, such as gift annuities and charitable remainder annuity trusts.
Q: What should a gift planner do in this environment?
A: Now may be an ideal time to review pending proposals for gifts that may be interest rate sensitive and to check examples on websites to ensure they are up to date. Prospects for lead trusts and retained life estate agreements should be reminded that these plans are more attractive during times of lower interest rates. Those who have been considering charitable gift annuities or charitable trusts should be sent new proposals showing how the charitable deduction has changed. Some donors who have been considering a charitable bequest may find the additional benefits of a life income gift more attractive and wish to make a gift in that way instead of or in addition to a bequest. This may be especially true for those who will no longer be subject to estate taxes and may wish to enjoy a lifetime of tax and other financial benefits.