Charitable Remainder Trust

Many people are unaware that their IRAs are poised to die when they do. In certain unpleasant combinations of circumstances, tax laws dictate that an IRA goes into liquidation within a year of the owner's death. Between estate taxes and income taxes, there probably won't be much left over for your heirs.

There is an out, however, that a lot of smart estate planners are recommending these days for people with $1 million-plus IRAs. You set up a charitable remainder trust to receive the IRA. Your heirs get income from the trust during their lifetime. When they die, the principal goes to a tax-exempt organization like a hospital, church or college.

There are two objectives to this strategy. One, of course, is to benefit a charity. The other is to postpone or eliminate the income tax bill on the IRA assets, thus benefiting the children or grandchildren. Your heirs, moreover, can get the lion's share of the benefits. In some cases, they can be left better off financially than if you had made no charitable bequest at all.

How do you get in this fix? It starts with an all-important deadline in the law on IRAs, the Apr. 1 after you turn 70 1/2. By that date you must make an irrevocable choice about how to take required minimum distributions from your IRA. The problem usually arises when IRA owners with spouse-beneficiaries choose payouts based on an annually recalculated life expectancy for both themselves and their spouses. Over the past ten years most people have chosen this so-called joint recalculation method because it results in the smallest possible distributions, and because it is pushed by IRA custodians and even Uncle Sam.

If the IRA owner dies before the spouse, all will be well. At that point the spouse can roll over the IRA into his or her name, appointing children, grandchildren or whomever as beneficiaries. Payouts can then be recommended over the joint life expectancies of the spouse and the young heirs, setting the stage for decades of tax-deferred compounding. These long-lived IRAs are known as "stretch-out IRAs".

The problem comes when the spouse dies first and the owner is past the Apr. 1 deadline. In that case, the IRA must be distributed to heirs in a lump sum within a year of the owner's death. For older couples where the husband is the IRA owner, there's as much as a 40% chance that the wife will die first.

The way out of this predicament involves naming a charitable remainder trust as beneficiary. An annual payout goes from this trust to your taxable heirs say, your children. The payout can be quite large, enough to consume all the income or even, if you want to push the envelope a little, bite a bit into the principal. When the children die, whatever is left in the trust goes to the charity.

This maneuver has little effect on estate taxes. There is a slight estate-tax deduction, calculated as the discounted present value of the future payout going to the charity. In most cases, this is going to be a small number.

Nor does the charitable remainder trust get any income tax exemption on its new earnings if they are going to the children. The aim of the game, rather, is simply to prevent an immediate income tax bill on the principal in the IRA.

Example: A husband and wife are 73 and 71, respectively. The wife is the prime heir of the husband's $3 million IRA, but if she dies first, then a charitable remainder trust kicks in as the contingent heir. Beneficiaries of the trust, besides the charity, will be their two children, ages 46 and 44.

In our example we'll suppose that the wife dies tomorrow and the husband the day after that. Without the charitable remainder trust, the IRA would be liquidated, creating, after a deduction for estate taxes, $1.8 million of taxable income. (We're assuming a separate fund was set up to pay the estate taxes.) Assuming a 39.6% income tax bracket, the children would be left with $2.3 million between them, in round numbers. Invested in bonds yielding 7%, this sum would generate a pretax income of $159,000 a year.

Now try the same estate with the benefit of the trust. The full $3 million of IRA principal escapes income tax. At that 7% the trust generates $210,000 a year of income for the children, a $51,000 improvement. They'd also get a modest saving on the estate taxes they are paying from other assets. And don't forget that the charity is a winner, too. It will get the $3 million someday.

This is a hypothetical illustration and is not intended to reflect the actual performance of any particular security.

A few caveats: The children (and their heirs) don't do very well with the charitable remainder trust if they die young. Also, if they were planning to put their inheritance into property that generates more capital gains than current income, the charitable remainder trust doesn't look so terrific.

There's always a chance that Congress will close the loophole that makes this sort of deal possible: the tax rule that says a charitable remainder trust is 100% exempt from tax on the IRA principal, even if the charity in question is getting far less than 100% of the trust's payouts.

Finally, in addition to, or in lieu of, the charitable remainder trust, you as IRA owner could start withdrawing more than the minimum required IRA distributions now. For the next three years this option can get you out of a 15% IRA surcharge, while a charitable remainder trust cannot.

UNDERSTANDING CHARITABLE REMAINDER TRUSTS

There are many benefits to be gained from donating to charity, aside from the warm fuzzy feeling it gives you. It can not only give you a tax deduction, but also another possible benefit: cash flow. A charitable remainder trust is one way to give to charity and potentially increase your cash flow.

Here's how a Charitable Remainder Trust works:

An individual donates an asset (usually a highly appreciated asset) to a charitable remainder trust. The asset is sold while in the trust and reinvested in an income-producing portfolio. The individual (plus any other non-charitable beneficiary) receives cash flow for life equal to:

• a fixed percentage of the value of the asset each year (charitable remainder unitrust-CRUT), or:
• fixed dollar amount (charitable remainder annuity trust-CRAT).

In either case, the individual also receives an immediate tax deduction equal to the fair market value of the asset minus the present value of the estimated future income stream, using IRS approved computation. There are no capital gains taxes due upon the sale of the asset inside the trust. A portion of the stream of income can be used to purchase life insurance to benefit the heirs (with tax-free proceeds) since the charity will ultimately receive the principal of the trust.

A Charitable Remainder Trust accomplishes several goals. First, it provides an opportunity to assist a favorite charity. Second, it can turn a non-income producing asset into an income-producing asset. It also reduces income and estate taxes. Finally, it helps add diversification to a financial portfolio and capital gains taxes are bypassed.

Let's take Fred and Ethel for example. Fred and Ethel, both 65, are ready to retire and move to Glendale, Arizona. They have stock with a fair market value of $750,000; an adjusted cost basis of $230,000 and annual dividends of $20,000. This stock represents 80 percent of their portfolio, and they are concerned about the lack of diversification. By donating the stock to a charitable trust benefiting their favorite charity (The Lucy Foundation), the trust can sell the stock and purchase a diversified portfolio of assets. Fred and Ethel will receive an income from the trust of about 6% ($45,000), which will be paid to them every year for life. They will also receive an income tax deduction of about $235,000 in the year of the gift, avoid the capital gains on the appreciated value of the property ($750,000-230,000), and more than double their income while diversifying the portfolio. Although Fred and Ethel have no children, they would like to provide an inheritance for their Godson, little Ricky. By taking a portion of their increased cash flow and purchasing life insurance in the amount of $750,000 (the donated amount), they can pass the benefits outside of their estate, and therefore, estate tax-free to little Ricky.

The investment profile is hypothetical, and the asset allocations are presented only as examples and are not intended as investment advice. Please consult your financial advisor if you have questions about these examples and how they relate to your own financial situation.

Documents establishing a charitable remainder trust must be carefully prepared to satisfy the requirements set by applicable portions of the Internal Revenue Code and Regulations. As a split-interest trust, the trustee has complete financial management responsibility for the donor's property placed in a charitable remainder trust. Generally, the trust must qualify as an annuity trust, a unitrust, or a pooled income fund. The donor retains an income interest for which he, she, or they receive income payments for a period that generally cannot exceed 20 years, or the remaining lifetime of the income beneficiaries. The charity receives the remainder interest upon termination of the income beneficiary's life interest in the trust assets; usually this occurs upon the death of the beneficiary or beneficiaries.

Starting with the tax year with the charitable remainder trust is established, the value of the remainder interest qualifies as a charitable gift deduction for purposes of the donor's income tax return. This deduction is subject to the 30-percent rule or the 50-percent rule as applicable according to the nature of the charity receiving the remainder interest. Excess contributions can be carried forward to the donor's income tax returns for up to five years. Any unused charitable deduction lapses at the end of the fifth tax year after the year the trust is established.

The amount of the tax-deductible remainder interest is determined from tables in Internal Revenue Service Publication 1457 (click here) and IRS Publication 1458 (click here) and IRS Publication 1459 (click here). Primary determining factors are the age of the income beneficiary or beneficiaries at the time income payments start, the applicable federal interest rate, and the qualification of the trust as an annuity trust, a unitrust, or a pooled income fund. Generally, the size of the remainder interest increases with the age of the beneficiary at the time income payments are to start. For a given age at the time income payments start, the size of the remainder interest is greater when the applicable federal interest rate is lower. When they have data on the type, amount, timing, recipient, and income beneficiary of a proposed gift, your legal and tax advisers can use Publication 1457 tables to provide you with an estimate of the remainder interest value for tax purposes.

Assets placed in a Charitable Remainder Trust meeting annuity trust or unitrust requirements are not included in the donor's estate for gift or estate tax purposes. If the donor's spouse is an annuity beneficiary, there are no gift or estate tax adverse consequences upon the death of the spouse. The trust assets are included in the spouse's estate and also are deductible from that estate as a charitable gift.

Income earned by an annuity trust or a unitrust charitable remainder trust is not subject to income tax unless the CRT has business taxable income not related to the charity beneficiary. Payments from the charitable remainder trust to the annuity beneficiary generally are taxable as ordinary income or capital gain income (short-term or long-term depending on circumstances). If annuity payments to the donor exceed the earning capacity of assets in the charitable remainder trust, part of the payment may be nontaxable distribution of the corpus of the trust. There are numerous other specific aspects of charitable giving using a charitable remainder trust that may or may not be important depending on your situation. Consult your tax and legal advisers before making decisions.

For Frequently Asked Questions about Charitable Remainder Trusts Click Here

Of course, this brief article is no substitute for a careful consideration of all of the advantages, and disadvantages of this matter in light of your unique personal circumstances.

Before implementing any significant tax or financial planning strategy, contact your financial planner, attorney or tax advisor as appropriate.