Are you asset rich but income poor? Do you have an appreciated asset that will incur a substantial capital gains tax? Will your estate be exposed to estate taxes? Are you charitably inclined? If you answered “yes” to any of the preceding questions, you may be a candidate for an underutilized, but highly effective, tool called the charitable remainder trust (CRT). Here’s how it works.
The process starts with a contribution of assets into an irrevocable trust. The trustee agrees to pay you an income each year for either your life or a term of years. If you select a term of years, as opposed to life payments, the maximum term is 20 years. The minimum payout you must receive is 5 percent, while the maximum is 50 percent. When the trust ends, the remainder of the assets in the trust pass to the charity. It’s as simple as that!
Not so fast.
The fact is, nothing in estate planning is that simple. However, with a basic understanding, you’ll soon see how a CRT might benefit your particular situation. Let’s take a closer look at some of the advantages CRTs provide.
Assume that Mr. and Mrs. Smith decided to fund a Charitable Remainder Annuity Trust (CRAT) with $250,000 of stock they purchased 20 years ago for $25,000. Because the CRT is tax-exempt, the trustee can sell the Smith’s stock tax-free and reinvest the full $250,000 in income-producing assets. Although a CRT is itself exempt from income tax and, therefore, pays no tax on any of it’s taxable income, the annuity payments made to the non-charitable beneficiaries carry out taxable income that is subject to tax at the beneficiary level. If the Smiths decided to receive monthly payments for 15 years and set the CRT’s payout rate at 6 percent, assuming the trust satisfies the required tests and further assuming the 7520 rate is 2 percent, the Smiths would receive an annual income of $15,000.
They would also be able to take a charitable deduction on their personal income tax return, based on the present value of the remainder interest passing to charity. If the Smiths’ deduction is limited on their current year’s tax return, IRS rules allow them to carry forward any excess for five years.
In addition to providing the Smiths with a potentially sizable income tax deduction and enhanced income, the Smiths will realize three additional benefits. First, since the $250,000 is no longer in their estate, they have effectively reduced their potential estate tax burden. Second, since there is no tax on the transfer, they have avoided the potential capital gains tax they would have faced had the stock been sold first. Finally, they have provided a significant gift to the charity of their choice.
One Step Beyond
This intriguing mechanism can be taken one step further. Let’s take one last look at Mr. and Mrs. Smith. When the Smiths first took the CRT into consideration, they may have felt some apprehension about transferring property out of their estate for the ultimate benefit of a charity rather than for their children. Sure, being a philanthropist would be nice, they thought. And, the potentially large charitable deduction and future income stream held great appeal. However, what could the Smiths have done to ensure their children would receive something similar (or, perhaps, even greater) in value to the transferred property? By using the savings from their charitable deduction, and possibly a portion of their monthly income stream, the Smiths could make gifts to an irrevocable life insurance trust (ILIT) which, in turn, would purchase a life insurance policy on the lives of Mr. and Mrs. Smith. Upon their death, the proceeds of the life insurance policy would be passed to the trust beneficiaries, their children, estate and income tax-free.
Philanthropy – It’s Up to You
While most people may be resigned to the inevitability of taxation, many may be unaware that they have a choice with respect to estate taxes. Since a certain amount of your money may go to society one way or another, the choice is in what form your “contribution” to society will be. When viewed from the perspective of channeling your funds through the government or directly to the charity of your choice, charitable giving takes on new meaning. The CRT may then become a valuable tool to facilitate this choice.
Note: The information contained in this blog post is not intended to, and cannot be used by anyone to avoid IRS penalties. You should seek advice based on your particular circumstances from an independent tax advisor.
Any discussion of taxes included in or related to this blog post is for general informational purposes only.