A Retirement Tax Trick You May Not Know About

Whether it’s a gift to your local church or a nonprofit environmental group, setting up a charitable remainder trust can help lower your tax bill in retirement. Photo: Steven Depolo

In my recent post I highlighted the looming problem that taxes will create for many investors when they retire due to the bulk of retirement assets being held in tax-deferred accounts. In that post I provided one potential solution for the tax-deferred problem: converting a portion of your portfolio to tax-free money via a Roth IRA conversion.

That solution is not viable for all investors. In this post I provide a second solution for reducing taxes and effectively increasing your retirement income. Here we will discuss the benefits of charitable trusts. There are several different types of charitable trusts, so I will limit this discussion to charitable remainder unitrusts (also known as CRUTs).

Charitable Trusts Aren’t Just for the Upper Class

Before I get into the details of what a CRUT is and how it works, I want to clear up the misconception that charitable trusts are only for the ultra-wealthy. This couldn’t be further from the truth.

You can typically create a charitable trust for $2,000 or less in legal fees and it offers middle-class investors the opportunity to save tens of thousands of dollars in income taxes, as we will see in our example later on. I would say a $2,000 outlay that saves you tens of thousands of dollars is a pretty darn good return on investment.

Plus, for middle-class investors, it’s a waste of tax savings to leave money to charity in your will rather than setting up a charitable trust while you are alive. Why you ask?

Leaving Money to Charity in Your Will Is a Waste of Tax Savings for Most Investors

When I give presentations and I ask the audience who plans to give some money to a charity or nonprofit when they pass away, typically half the people in the room raise their hand. Nonprofits these days run the gamut from your local church to organizations fighting cancer to groups preserving wildlife habitat and so on.

The problem is, most of these people plan to donate the money via a bequest in their will. Why is that a problem?

Because for most people, a donation in your will doesn’t offer any benefit to you, whereas if you set up the donation via a charitable trust while you are alive, you receive an immediate tax deduction to use against your income taxes.

When you donate money in your will, your estate, not you (since you’re dead), gets the tax deduction to offset any estate taxes that are due. However, your estate likely doesn’t need the tax deduction.

For example, in 2015 you can pass along over $5.4 million (over $10.8 million for a married couple) before any estate taxes are due. I don’t have the statistics in front of me, but I would guess that $10.8 million for a married couple takes care of the vast majority of estates in the United States.

So, if you want to leave some money to a good cause, doesn’t it also make sense to benefit yourself if you have the option? When you set up a charitable trust, you receive an immediate deduction to use against your income taxes while you are alive.

And you need this tax deduction. As I highlighted in my previous post, middle-class investors are facing federal and state income tax bills that could drain 25% or more of their 401(k), traditional IRA, and other tax-deferred retirement accounts, and they don’t even realize it.

So What Is a CRUT and How Does It Benefit Me?

A charitable remainder unitrust (CRUT) is a type of charitable trust that has existed in the tax code for decades. CRUTs allow you to reduce your income taxes during retirement, thereby helping you to maximize your retirement income.

Here’s how they are structured: You, the donor, designate a portion of your retirement savings that you want to transfer into the charitable trust. You are then required to receive income back from the trust for the rest of your life. (That sounds like a good deal, right?)

When you pass away, whatever is left in the trust at that time goes to the nonprofit (or nonprofits) you designated in the trust to receive the money.

The amount of annual income you receive from the trust each year must be between 5% and 50% of the trust assets. You select the percentage at the time of the trust formation.

Based on your age when you set up the trust and the income percentage you elect to receive each year, you receive, while you are alive, an immediate deduction to use against your income taxes. Let’s take a look at an example.

Suppose you’re 65 years old and put $200,000 into a CRUT. Further suppose you chose to take 6% of the trust value as income back to yourself each year.

On the initial trust value, that would be $12,000 in income to yourself. Based on your age (65) and the income percentage you chose (6% of annual trust value), the IRS actuarial tables dictate that you would receive an income tax deduction of approximately $77,000 on the $200,000 you put into the trust!

You can then use the income tax deduction to help you and your family in a couple of different ways. You could use it to offset taxable income from your tax-deferred accounts. Or you can also use the tax savings to put money into tax-free vehicles for your children (this gets into highly advanced planning topics beyond the scope of this post).

The important point is you get a significant income tax deduction that greatly aids your retirement financial planning, and, at the same time, you’re contributing to a cause that you’re passionate about.

Additional Details and FAQs About Charitable Remainder Trusts

CRUTs definitely fall into the category of advanced financial and estate planning, so you will need to work with tax and legal professionals who have experience with them. If the trust does not get set up correctly, then it will lose its tax advantages under the code.

The following are some further details and frequently asked questions about CRUTs:

Will the annual income I receive from the trust be the same each year? No. The income from a CRUT is based on a fixed percentage of the annual value of the trust, not a fixed dollar amount. (You choose the percentage, between 5% and 50%, at the time of formation, as discussed above.) Since the value of the trust will fluctuate from year to year, that means the value of your income will change each year too. Charitable remainder annuity trusts (CRATs, not discussed in this post) provide for a fixed dollar amount of income each year, regardless of the value of the trust.

This question also brings up a couple other important points:

• Since you’re required to determine the value of the assets in the CRUT each year in order to calculate how much income you receive, it is a good idea to contribute assets with easily ascertainable values, such as publicly traded securities. Otherwise you will be spending inordinate amounts of money every year obtaining qualified appraisals of the assets.
• Although you can technically choose up to 50% of the trust value as income back to yourself under the IRS rules, in reality this is not practical. Your tax deduction would essentially be zero since the actuarial prediction is that you would be virtually certain to drain the trust before you pass away. (Most people choose between 5% and 8% each year since that range typically provides a good balance between the income they want back and the tax deduction they will receive.)
• You also must choose an income percentage in a range such that the combination of your age and the income result in an actuarial prediction that at least 10% of the trust value will go to the charity.

Can I designate more than one charity to receive the remaining money when I die? Yes, multiple charities can be designated in the trust.

When must I choose which charities receive the money when I die? You must choose the charities at the time you form the trust. Note also that charitable trusts are irrevocable in nature. Unlike revocable trusts, once you set up the trust you cannot change your mind.

How is the income I receive from the trust taxed? It depends on the taxable nature of the assets put into the trust. In other words, if you contributed a tax-deferred traditional IRA into the trust, then it still gets taxed as ordinary income to you as you receive it from the trust each year, just as it would be if you hadn’t created the trust. However, a CRUT does allow you to defer and spread out taxable gains.

Although I have primarily focused on funding CRUTs with tax-deferred accounts, they are also often funded with taxable accounts to spread out taxable gains due to the tax-deferred nature of the CRUT itself. Here’s an example.

Suppose you bought Apple stock several years ago in a taxable account for $10,000 and due to the company’s explosive growth the stock is now worth $100,000. You would like to sell and diversify out of this holding now, but you also don’t want to realize the $90,000 of taxable gains all at once.

If you contribute this stock into the CRUT, you can immediately sell it and purchase new holdings, but you don’t pay all the tax now. The taxable gain is tracked inside the trust and you pay it in small doses as the gain is distributed to you as income each year in smaller chunks.

What if I don’t need such a large tax deduction this year? The tax deduction carries forward into future years. The rules on deductions and carryforwards are complex. This is definitely an area where your tax advisor will need to help you navigate through it.

If I’m married, can the CRUT be created to pay income to us until both of us die? Yes, but the tax deduction will be reduced since the actuarial prediction is that the value of the trust will be reduced more before it goes to the charity.

At what age does it make sense to set up a CRUT? Probably when you are at least 60 — for a couple of reasons. One is that once you create the CRUT you are required to take income from it. Since retirement accounts are often used to fund the CRUT, you don’t want to mistakenly turn on distributions before you want them or before you can legally take them without penalties. Second, the older you are the higher the tax deduction you will receive for forming the trust.

Once I set up a CRUT can I contribute more to it? Yes, you can make additional contributions into the CRUT at later dates.

Tim Van Pelt is a financial advisor and registered investment advisor representative of Steele Capital Management, Inc. The views expressed in this article are solely his and do not necessarily reflect the views of Steele Capital or its management. Mr. Van Pelt specializes in advanced financial planning techniques to help clients advantageously utilize the tax and estate planning code along with smart portfolio planning to maximize retirement income. He helps his clients assemble financial plans that properly fit together with their retirement planning, tax planning and estate planning. You can reach him at tjvanpelt@gmail.com or (608) 577-9877. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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