When it comes time to plan your estate (and remember, it is never too early), there are a number of important considerations you will need to keep in mind. From making sure the right assets go to the right people at the right time to ensuring that you will continue to have sufficient access to your wealth later in life, estate planning is a complex process that requires thoughtful introspection and a careful attention to detail.
Along with these types of considerations, many people also choose to make charitable giving a part of their estate plan. Then, of course, there are tax considerations, which absolutely must be addressed as well. Tying all of these considerations together, one estate planning tool that many people find useful is what is known as the “charitable remainder trust.”
What is a Charitable Remainder Trust?
A charitable remainder trust is an estate planning tool that allows you to donate a portion of your wealth to charity while securing tax benefits for your estate and providing you with an income source during your lifetime. Here’s how it works:
Step #1: Choose Your Charity and Establish the Trust
First, you must establish the trust. This involves preparing the necessary paperwork with the help of your estate planning attorney. When you set up the trust, you will need to name the charity that will serve as trustee. Your chosen charity must be approved by the IRS, which generally means that it must have secured tax-exempt status. For charitable organizations, this most often means a 501(c)(3) designation.
Step #2: Decide On Your Income Stream
When you set up a charitable remainder trust, the trust (managed by your chosen charity) pays you a certain amount either (i) for a fixed number of years during your lifetime, or (ii) for the remainder of your life until death. There are two primary ways to structure these payments:
- Fixed Annuity – The first option is to receive an annual fixed annuity. With this option, you receive the same amount from the trust each year, regardless of the trust’s investment performance. Higher payments will increase your income tax obligation (more on taxes below) and potentially draw from the trust’s principal; so, if you choose the fixed annuity option, you need to make sure that your chosen payment amount satisfies your income, tax savings, and charitable objectives.
- Percentage of Assets – The second option is to receive a percentage of the trust’s assets on an annual basis. Under IRS rules, you must draw at least five percent, though again you want to be careful not to draw too much and risk losing the tax and charitable benefits of establishing the trust.
Step #3: Fund the Trust
Finally, you need to fund the trust. Since the primary tax benefits come from avoiding capital gains on appreciated property, in most cases this involves transferring securities or other appreciated assets into the trust. The charity (as trustee) may then choose to dispose of the assets, avoiding capital gains tax, and acquire other income-producing assets that better serve the charity’s investment objectives.
How Charitable Remainder Trusts Work: An Example
John Smith owns $500,000 in appreciated stock that he wishes to donate to the American Red Cross upon his death. His total estate is worth several million dollars, making estate taxes a significant concern. As a result, he decides to establish a charitable remainder trust, naming the American Red Cross as the trustee, and using the $500,000 in stock to fund the trust.
John wants to diversify his retirement income, but his primary goals are charitable. So, he decides to draw the IRS-minimum five percent from the trust annually. During the first year of the trust’s existence, the American Red Cross sells the stock (capital gains tax-free) and buys mutual funds that earn a 10 percent return.
At the end of the year, John receives $27,500 (five percent of $550,000). The American Red Cross has $527,500 remaining in the trust to invest next year. John must pay income tax on the $27,500 payment (as estimated in advance), but he does not have to pay capital gains tax on the original gift stock’s appreciation. Upon John’s death, the annual payments will end and the American Red Cross will take outright possession of the trust’s assets as a charitable donation. Since the gift was made through a trust (meaning that it was no longer John’s property at the time of his death), it avoids the estate tax entirely.
More On the Tax Benefits
To summarize the tax advantages of charitable remainder trusts identified in the above example, when you form a charitable remainder trust, you realize three different tax benefits:
- Capital Gains Tax. Since charities do not have to pay capital gains tax, establishing a charitable remainder trust avoids capital gains tax on any appreciated property that you donate through the trust.
- Estate Tax. Like other forms of trusts, a charitable remainder trust removes wealth from your taxable estate. As a result, the value of your donation is not subject to estate tax upon your death.
- Income Tax. With a charitable remainder trust, you only pay income tax on the amount you expect to receive back from the trust, and you take a deduction spread over five years for the value of your charitable donation.
Key Facts About Charitable Remainder Trusts
If you think that a charitable remainder trust may be a good addition to your estate plan, before you commit, here are some key facts to keep in mind:
- Charitable Remainder Trusts Are Irrevocable Trusts. Unlike the popular revocable living trust, charitable remainder trusts are irrevocable trusts. This means that, once you create the trust, it will exist for the duration. As a result, if you are concerned that you may need access to the trust’s principal during your lifetime, or if you want to reserve your decision about making a charitable donation for a later date, a charitable remainder trust may not be your best option.
- Forming a Charitable Remainder Trust Typically Requires a Sizable Donation. In order for establishing a charitable remainder trust to make sense for you and your chosen charity, you will generally need to make a fairly sizable donation. For smaller donations, there are other options that may prove to be more beneficial for all parties involved.
- The Charity is in Control. Unlike revocable trusts and other self-settled trusts where you (or your designated representative) serve as the trustee, with a charitable remainder trust, the charity takes responsibility for managing the trust’s assets during your lifetime. If the charity mismanages the trust, you could lose your principal, and lose out on the charitable and income-producing advantages you sought when you established the trust.
But, under the right circumstances, forming a charitable remainder trust can have significant benefits. If you are considering a sizable charitable donation (or multiple sizable donations) as part of your estate plan, you should be sure to discuss the charitable remainder trust with your attorney.
Jiah Kim & Associates | Experienced Estate Planning Attorneys
If you would like more information about your options for including charitable giving as part of your estate plan, we invite you to contact us for an initial planning session. To schedule an appointment at your convenience, call Jiah Kim & Associates at (646) 389-5065 or contact us online today.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.