Charitable Remainder Trusts (CRTs) have proven to be a useful tool used in tax-efficient investing. This article discusses the basics of CRTs and examples of how you can use these vehicles to better manage your tax liability in retirement.
The CRT Basics
A CRT is an irrevocable split interest trust. The trust is “split” between non-charitable beneficiaries (i.e., you) and charitable beneficiaries that you select. A percentage of the trust assets are distributed back to you as the current beneficiary. These distributions must be at least 5%, but no more than 50%. You can also set up your CRT to last for your lifetime or for a term of up to 20 years. When the trust ends, the “remainder” of assets within the trust are then distributed to the charities you selected in the trust document. Last, but not least, a significant charitable income tax deduction may be generated in the year you fund your CRT. The income tax deduction is measured by the present value of the charity’s remainder interest and must be worth at least 10% of the value of the trust upon creation.
As you can see there is a fair amount of flexibility in deciding the terms of your CRT. How you structure your CRT will be driven largely by your cash flow objectives and the tax planning goals you are trying to achieve.
The Types of CRTs
There are largely two types of CRTs. A Charitable Remainder Annuity Trust (CRAT) and a Charitable Remainder Unitrust (CRUT). There are also two additional variations of the CRUT, namely the NICRUT which stands for the Net Income CRUT, and the NIMCRUT which is a Net Income with Make-up CRUT.
The CRAT. With a CRAT, your payments are fixed at inception and based upon a percentage of the initial value of the trust. Therefore, your payments will not vary over the term of the CRAT. This is a significant structuring factor to consider since you would not want to set your annuity payment to exceed the projected growth rate of the assets within the trust. If this happens then you may exhaust the CRAT – especially if the assets within the CRAT experience a significant decline. Also, by the fixed nature of the CRAT payments, there is no adjustment in the amounts paid, and thus no theoretical inflation adjustment to what you might be receiving.
The CRUT. The payments from the CRUT are adjusted annually based upon the value of the trust assets at the beginning of the year. Therefore, if your CRUT assets grow, so does your annuity payment. This can be viewed as a helpful factor to increase your payments over time like an inflation adjustment. Conversely, if your assets drop, and/or your payments are set at a higher rate over time than your investments perform, then your annuity payments will also drop. The silver lining here is that your CRUT would theoretically never be exhausted since the annuity is based upon a percentage of the assets. Of course, if your investments did go to zero then so would your annuity payment.
The NICRUT. This CRUT is similar to the plain vanilla CRUT described above except that the annuity payment is limited to the lesser of the set percentage of your trust’s payout or the actual income of the trust.
The NIMCRUT. In the NIMCRUT, the annual distribution is limited to the amount of income up to the annual distribution percentage you specified when setting up the CRT but takes the net income only CRUT one step further by adding a “Make-up” provision in the trust. When the income is less than the set payout percentage then that “deficit” is carried over and made up in a year when there is income in excess of your set payment percentage. The NIMCRUT is often used as an alternative to qualified pension plans by investing in low income producing assets while the donor is in their high-income years, and then switching their asset allocation to high yielding assets in their retirement years.
The Tax-Efficiency
How does a CRT bring tax-efficiency to your situation? First, the CRT is a tax-exempt entity. Therefore, a CRT can generate and accumulate income and capital gains without paying any taxes. This would stay the case throughout the entire term of the CRT as long as no investments are made that generate Unrelated Business Taxable Income (UBTI). The IRS says that “For most organizations, unrelated business income is income from a trade or business, regularly carried on…” In other words, be very careful if investing directly in any operating businesses or private equity that will generate more than $1,000 of UBTI in your CRT or you might owe taxes on this income. Second, CRTs can generate significant charitable contribution deductions in the year funded. For example, if you are 65 years old and fund a lifetime CRUT with $500,000 and a 6% unitrust payment, you would generate a charitable deduction of approximately $198,000. This is a sizeable charitable deduction and when this large, we have to be careful of running into charitable deduction limitations. For the donation of a publicly traded stock with a long-term holding period, the deduction may be limited to 30% of your Adjusted Gross Income (AGI) assuming the type of charitable remainder beneficiary is a public charity. Using the charitable deduction above and assuming that your Adjusted Gross Income was $450,000 in the year you funded your CRT, then only $135,000 would be deductible in the current year ($450,000 x 30% = $135,000). The remaining $63,000 ($198,000 less $135,000) would then be carried forward for up to 5 more years with the same 30% AGI limitation applied. See Chart 1 below for a range of deduction limitations depending upon the asset donated to your CRT and the ultimate charitable beneficiary.
Chart 1
Third, the CRT four-tier system of income categorization may allow you to take advantage of tax-preferential portfolio income. Since CRT payouts are taxable to you, knowing how this system works will allow you to structure your asset allocation in a way to help your distributions be more tax efficient. The four tiers are as follows: (1) Ordinary income and qualified dividends, (2) capital gains (short-term, depreciation recapture, long-term gain), (3) other tax-exempt income; and (4) return of principal. The higher tier of income must be fully exhausted before any income is paid from the next tier. Some practitioners call this “worst first”, meaning that the worst taxable income (e.g., ordinary interest) is paid out first before the preferential income is paid out (e.g., qualified dividends). Therefore, you may be able to structure the CRT’s asset allocation to earn minimal ordinary interest and favor qualified dividends (which are taxed at preferential long-term capital gains rates). Also keep in mind that the income is doled out pretty consistently which better allows you to assess projected tax liability and manage your capital gains better. If you fund a highly appreciated asset to the CRT and sell it, then a big chunk of your distribution may be comprised of capital gains. This is great from a planning perspective since you know a certain amount of gains will be passed out to you and you can also tax loss harvest against those gains to help make your CRT distribution be more on a tax-free basis.
How to Use in Retirement
Now that you have an idea of how CRTs work, let’s discuss how you might use a CRT to make your retirement more tax efficient.
Selling Employer Stock (Concentrated Position) at Retirement. The CRT is a useful tool to help you sell a highly appreciated asset. You may be a public company executive nearing retirement and have built up a significant holding in your company’s stock. You may also be fortunate enough to have significant appreciation in this stock. Now you may want to diversify this concentrated stock position, but you may be reluctant to do so because of the large capital gain. You can contribute a part of your stock to a CRT, sell the stock within the CRT and defer the capital gains over the term of the trust. Since the CRT is tax-exempt, no taxes will be due by the trust and 100% of the proceeds can be reinvested in your trust to grow for you. In addition, you will have generated a charitable deduction. This deduction can help offset some of the other gains on the stock that you did not contribute to the CRT. In this scenario, the CRT allows you to defer taxes on the sale of your stock within the CRT and reduce taxes on the gain generated outside of the trust.
Portfolio Rebalance at Retirement. Upon (or leading up to) your retirement you may wish to rebalance your portfolio to (1) be more conservative and (2) generate more income. Employing the use of a CRT may allow you to conduct this rebalance in a tax-efficient manner. For example, if you are selling off your equity holdings to rebalance into more fixed income, then you can effectively cherry pick the positions with the most appreciation and contribute those to the CRT to be sold. The charitable deduction generated reduces your taxable income similar to the discussion above. In addition, you will be setting up an annuity payment from your CRT to generate income in your retirement. You may view this annuity payment as effectively replacing your paycheck after retirement.
Creating a Supplemental Retirement Plan. If you are a professional (e.g., dentist) that has fully funded all of your qualified plans, a NIMCRUT might help you accumulate additional retirement funds for your retirement in a tax-efficient manner. Assume that you contribute $25,000 (after tax funds) each year to your NIMCRUT. Since you are still working, the asset allocation for the NIMCRUT would be invested for maximum growth and very little current income. Remember that the annual distribution from a NIMCRUT is limited to the amount of income up to the annual distribution percentage you specified when setting up the CRT. So, for example, you could set up the NIMCRUT to distribute 6% to you on an annual basis. But, you construct your asset allocation such that the only income you expect to generate would be about 1.5% in qualified dividends from the CRTs investment in equities. Therefore, your distribution would be limited to the 1.5% of income since it is less than the annual CRT percentage of 6%. This would also create an annual deficit (6% payout less 1.5% net income) in the payout which accumulates and could be made up in the future. At retirement, you can rebalance your CRT asset allocation to maximize yield and make more income available to be paid out under the make-up provision of the CRT. When the CRT generates more income in a year than the specified percentage and there was a deficit in the prior year, you are allowed to make up the deficit. The NIMCRUT allows you better control over the income recognized from year-to-year, allowing you to plan for long-term tax-efficiency.
Defer IRA Required Minimum Distribution. This new opportunity under The SECURE 2.0 Act allows individuals who are 70 ½ or older to elect as part of their Qualified Charitable Distribution (QCD) limit a one-time gift of up to $53,000 from their IRA to a CRT. This amount also qualifies towards an annual RMD (if applicable). This has the effect of reducing your taxable RMD in the year the CRT is funded, and possibly reduced payments from the CRT depending upon the type of CRT used. This strategy should be evaluated carefully to make sure that the cost to set up the CRT is worth the additional complexity. Since this is a per taxpayer limitation, both spouses could set up their own CRTs, helping to this worthwhile.
Summary
Charitable Remainder Trusts (CRTs) are flexible vehicles that can be designed to fit many tax situations. As you contemplate retirement, consider using a CRT to better manage your tax liability while providing you a cash flow stream and ultimately benefitting your favorite charities.
All written content is for information purposes only. Opinions expressed herein are solely those of Stinnett Wealth Planning, LLC unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant, or legal counsel prior to implementation.