How to Secure a Lifetime Income, Save Taxes & Benefit a Charity
1. What does a CRT do?
A CRT lets you convert a highly appreciated asset (stock, real estate, etc.) into lifetime income. It reduces your income taxes now and estate taxes when you die, and you pay no capital gains tax when the asset is sold. Plus, it lets you help a charity(ies) that has special meaning to you.
You transfer an appreciated asset into an irrevocable trust. This removes it from your estate, so no estate taxes will be due on it when you die. You also receive an immediate charitable income tax deduction.
The trustee then sells the asset at full market value, paying no capital gains tax, and re-invests the proceeds in income-producing assets. For the rest of your life, the trust pays you an income. When you die, the remaining trust assets go to the charity(ies) you have chosen. That's why it's called a charitable remainder trust.
Years ago, Max and Jane Brody (ages 65 and 63) purchased some stock for $100,000. It is now worth $500,000. They would like to sell it and generate some retirement income.
If they sell the stock, they would have a gain of $400,000 (current value less cost) and would have to pay $60,000 in federal capital gains tax (15% of $400,000). That would leave them with $440,000.
If they re-invest and earn a 6% return, that would provide them with $26,400 in annual income. Multiplied by their life expectancy of 26 years, this would give them a total lifetime income (before taxes) of $686,400. Because they still own the assets, there is no protection from creditors and no charitable income tax deduction is available.
The trustee will sell the stock for the same amount, but because the trust is exempt from capital gains tax, the full $500,000 is available to re-invest. The same 6% return will produce $30,000 in annual income which, before taxes, will total $780,000 over their lifetimes. That's $93,600 more in income than if the Brodys had sold the stock themselves. And because the assets are in an irrevocable trust, they are protected from creditors.
The trust will be re-valued at the beginning of each year to determine the dollar amount of income you will receive. If the trust is well managed, it can grow quickly because the trust assets grow tax-free. The amount of your income will increase as the value of the trust grows.
Sometimes the assets contributed to the trust (like real estate or a closely-held corporation) are not readily marketable, so income is difficult to pay. In that case, the trust can be designed to pay the lesser of the fixed percentage of the trust's assets or the actual income earned by the trust. A provision is usually included so that, if the trust has an off year, it can "make up" any loss of income in a better year.
This option is usually a good choice at older ages. It doesn't provide protection against inflation like the unitrust does, but some people like the security of being able to count on a definite amount of income each year. It's best to use cash or readily marketable assets to fund an annuity trust.
In either (unitrust or annuity trust), the IRS requires that the payout rate stated in the trust cannot be less than 5% or more than 50% of the initial fair market value of the trust's assets.
The income can also be paid to your children for their lifetimes or to any person or entity you wish, providing the trust meets certain requirements. In addition, there are gift and estate tax considerations if someone other than you receives it. Instead of lasting for someone's lifetime, the trust can also exist for a set number of years (up to 20).
It is usually limited to 30% of adjusted gross income, but can vary from 20% to 50%, depending on how the IRS defines the charity and the type of asset. If you can't use the full deduction the first year, you can carry it forward for up to five additional years. Depending on your tax bracket, type of asset and type of charity, the charitable deduction can reduce your income taxes by 10%, 20%, 30% or even more.
However, because of the experience required with investments, accounting and government reporting, some people select a corporate trustee (a bank or trust company that specializes in managing trust assets) as trustee. Some charities are also willing to be trustees.
Before naming a trustee, it's a good idea to interview several and consider their investment performance, services and experience with these trusts. Remember, you are depending on the trustee to manage your trust properly and to provide you with income.
You can take the income tax savings, and part of the income you receive from the charitable remainder trust, and fund an irrevocable life insurance trust. The trustee of the insurance trust can then purchase enough life insurance to replace the full value of the asset for your children or other beneficiaries.
Life insurance can be an inexpensive way to replace the asset for your children (every dollar you spend in premium buys several dollars of insurance). Insurance proceeds are available immediately, even if you and your spouse both die tomorrow. And, in addition to avoiding estate taxes, the proceeds will be free from probate and income taxes.
You convert an appreciated asset into lifetime income. You receive an immediate charitable income tax deduction, reducing your current income taxes. You remove the asset from your estate, reducing estate taxes that are due when you die. And because you pay no capital gains tax when the asset is sold, you receive more income than if you sold it.
With the life insurance trust replacing the full value of the asset, your children receive much more than if you had sold the asset yourself, and paid capital gains and estate taxes. Plus the proceeds are free of income and estate taxes, and probate.
Finally, you will make a substantial gift to a favorite charity. And because the charity knows it will receive the gift at some point in the future, it can plan projects and programs now - benefiting even before receiving the gift.