Remaining retirement savings trusts and charitable funds
By Clint Camua, CFP
With rising prices for both stock market and real estate assets, the prospect of paying exorbitant capital gains taxes is becoming increasingly worrying. Additionally, with legislation to increase taxes on these earnings to pay for public spending, having a strategy to minimize and / or avoid these taxes is gaining popularity. For those who are inclined towards charity, there are even more opportunities to combine different charitable strategies to satisfy both the desire to potentially lower taxes and the desire to give to worthy charity. This is where using the Charitable Remainder Trust (CRT) can come in handy.
This article will cover the following points:
Two types of CRT
Tax advantages of CRTs
CRT income benefits
Benefits of a Donor Advised Fund (DAF) as the remaining beneficiary
How a CRT can fit into your overall financial plan
As with any strategy that may involve tax and / or estate ramifications, it is important to review all recommendations with your tax and estate lawyer. Let’s get started.
Two types of charitable residual trusts
CRT can be divided into two different types: Charitable Remainder UniTrust (CRUT) and Charitable Remainder Annuity Trust (CRAT). Both trusts have the charity as the “remainder” or beneficiary of the capital once the interest on the income ends. This means that before the charity is paid out, the trust income is paid to a beneficiary other than a charity for a period of time or for the rest of the life of the income beneficiary.
A CRUT differs from a CRAT in the way the income payment is calculated. For example, in a CRUT with a 5% payout, the 5% is calculated based on the value of the CRUT each year. This payment will fluctuate depending on the performance of the assets of CRUT. In a CRAT, payments are set on the basis of the initial amount of the contribution. Thus, payments do not fluctuate regardless of CRAT’s performance.
Tax treatment of residual charitable trusts
The CRT can be funded with highly valued assets, as the sale within the CRT does not result in any capital gains tax for the donor. This is sometimes why some call the CRT the “Capital Gains Avoidance Trust”. From there, the proceeds can be reinvested in an appropriate manner to distribute the necessary income while potentially increasing to have remaining assets for the charity. An administrator is hired to assess trust to ensure compliance. The administrator may advise the trustee on the amount of the distribution each year to comply with the guidelines.
Where this can be useful is for someone who has highly valued assets or concentrated positions but has been reluctant to sell due to capital gains. There can be several reasons for selling a highly valued asset:
Low or insufficient income from valued asset
Reduction of overall portfolio risk
Donated assets can be liquid securities or other assets such as real estate or shares in a private company.
Tax treatment of a contribution
Since the charity is a “remaining” beneficiary, you will not be able to deduct the full amount of the contribution to the CRT. The income payments you choose and the length of the CRT will determine the percentage of the deduction. Typically, planners who advise in this area have software that will help calculate the rough deduction based on the inputs. Generally, the higher the income payment, the lower the deduction. In addition, it is possible that the longer the term, the lower the deduction. It is always recommended to consult your tax professional before implementing and determining the strategy to be used.
One thing to note is that if you donate highly valued long-term capital gains assets, you can only give up up to 30% of adjusted gross income. The rest can be carried over for five years. This can influence the amount of assets you contribute to the CRT.
Income from remaining charitable trusts
As mentioned earlier, whether you choose the UniTrust or Annuity Trust option, you can design an income stream from the trust. Depending on the type of asset in the CRT, the taxation will vary. CRTs follow a tiered system. Through IRC Sec. 664 (b), “The character of this income is classified into four levels which must be distributed in the following order” – ordinary income, including the current year and accumulated income, and eligible dividends; capital gains; other income exempt from tax; and the return of capital.
As stated on CalCPA, “With CRATs and CRUTs, the IRS requires that the payment rate each year cannot be less than 5% or greater than 50% of the initial fair market value of the trust assets. Here is why this is important. If the donated asset earns little or no income, you can potentially turn that asset into an asset that can generate cash flow.
A fund advised by donors as the remaining beneficiary
As described above, the charity is the “remaining” beneficiary. For many, this is a difficult choice because you may have multiple charities that you want to benefit from. Additionally, there is the underlying concern that the charity may not exist at the time of receiving the funds.
One solution that may make sense is to use a Donor Advised Fund (DAF) as the CRT beneficiary. From a tax perspective, a CFO can be treated like a charity. Many custodians offer these accounts for donations to charities in an easy way. With a CFO, you can not only control how you fund it, but you also control how quickly you distribute assets to charities that you can support. Plus, you don’t have to name the charities when you create the CRT. You can name specific charities and / or the CFO as the remaining beneficiaries.
In some cases, a DAF is used as a way to educate the younger generation on how to donate to charity and understand the importance of giving. They can even serve as a DAF successor in making donation decisions to charities important to their families.
How a charitable residual trust fits into your overall financial plan
Perhaps the most important point to emphasize when it comes to using the CRT strategy is that the principal of the donated asset will go to the charity rather than a family beneficiary. Therefore, it is important before considering this strategy that one has the propensity to donate to charity.
There are certain strategies you can incorporate to “replace” a portion of the donated asset. As long as you qualify, incorporating life insurance may make sense, as a portion of the CRT’s income can be used to pay premiums.
As with any strategy, it’s important to use CRT in the context of your overall financial plan. Sometimes something that looks good on its own may not look as good in the context of other inputs, so it’s important to tie it back to the plan. Confirming that using a CRT will improve your financial plan can help increase your confidence in the decision. Additionally, in the plan you can fine tune variables including how much to donate, how it changes your tax situation, impact on your cash flow, amount left to heirs with or without life insurance, etc. .
In summary, a CRT can be a useful strategy in the right circumstances. The ideal candidate should be prepared to donate to charity and have highly valued securities to donate that would benefit from the avoidance of capital gains tax. Potential side benefits include additional cash flow, tax deduction, and diversification from concentrated positions or over-allotment to a particular asset class. If you can benefit from the above, consider contacting your advisor and discussing the details.
About the author: Clint Camua, CFP®
Clint Camua, CFP®, MBA, is Regional Director and Partner at EP Wealth Advisors. He is based in offices in West Los Angeles and Westlake Village, California. Clint has nearly 30 years of experience in the investment industry. His experience covers brokerage and wealth management. Clint encourages informed decision making among clients and encourages them to understand their behavioral tendencies. The information provided is not intended to be regarded as individual investment advice and is not intended to replace it. Neither Clint Camua nor EP Wealth Advisors provide tax or legal advice. Always consult with a tax and legal professional before employing a sophisticated CRT strategy or any other referenced here.
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