Several years ago, a retiree came to the New York offices of Richard Baum to ask about increasing his income stream. All his assets were well-invested, except one: a prized painting. “It had been in his family for many years and appreciated in value quite a bit,” recalls Baum, a CPA, attorney and partner at financial advisory firm Anchin, Block & Anchin. “So I suggested he donate the artwork to charity.”
That may sound counterintuitive. But carefully managed charitable contributions can actually boost retirement income. For many clients, of course, it works the other way around. Charitable giving is a priority—and if they can do it without jeopardizing their income stream, so much the better.
Either way, there are several strategies to enable clients to do well while doing good, or vice versa.
Charitable Remainder Trusts
One of the primary instruments is the charitable remainder trust. This proved the perfect solution for the retiree with the cherished artwork. “Selling it outright would trigger high capital gains taxes,” says Baum. “But if instead he put it in a charitable remainder trust, he would get a charitable deduction off his income taxes, receive a payout from the trust every year and defer the capital gains tax.”
With a charitable remainder trust, the trust sells the donated assets and invests the proceeds in income-bearing securities, which are then used to pay benefits to the donor, a spouse or even children. Payments can continue for the remainder of their lives or a set period of time up to 20 years, as long as at least 10% of the original value of the donation remains at the end for a designated charity or charities.
The donor can change charities at any point. In the case of the painting owner, he named his own foundation as the charity.
Calculating Payout Rates
The size of the payouts—which can be quarterly, semiannual or annual—is preset from the start and cannot be changed. How they are calculated, though, depends on several variables.
“Broadly speaking, there are two types of charitable remainder trust,” says Gregory B. Gagne, managing member of the Affinity Investment Group in Exeter, N.H., and a 15-year member of the Million Dollar Round Table, a trade association. “A charitable remainder annuity trust pays a set dollar amount, and a charitable remainder unitrust pays a set percentage of the corpus of the trust.”
With the former, the payout is between 5% and 50% of the trust’s initial fair market value. For the unitrust, it’s between 5% and 50% of the trust’s annual fair market value, which is re-determined every year. Thus, the income stream from a unitrust will vary.
Unitrusts have other differences from their annuity counterparts. First, donors can make multiple transfers into them. Second, the principal can be protected by designating it a “net income” unitrust, which never pays out more than the income generated in a given year, even if that’s short of the preset payout percentage. Alternatively, a “net income with makeup” unitrust will make up the difference in subsequent years if the trust’s earnings improve.
Finally, a “flip” unitrust allows donors to delay payouts until a specific date or event. For instance, a “net income” unitrust could switch to a standard unitrust after a certain number of years or a grandchild is born. “People who are still in their income-generating years can get the charitable deduction without having to take the income until they retire,” suggests Chris Hobart, president of Hobart Financial Group in Charlotte, N.C. “They can basically flip it on whenever they’re ready.”
But the tax benefits aren’t quite as good as they might seem. The charitable deduction isn’t for the full amount of the donation, Baum explains. The IRS subtracts the total income the trust is likely to pay the donor—based on the beneficiary’s age and life expectancy, the payout rate, and an IRS index known as the Applicable Federal Rate. The older the donor, and/or the shorter the duration of the trust, the larger the deduction will likely be.
“Also, CRTs don’t really eliminate the capital gains tax. They merely defer them,” adds Baum. Here’s how it works: When the trust sells the donated assets, the capital gain is recorded. Any interest and dividends the trust generates as a result are taxed as ordinary income when distributed to the donor. If the distribution exceeds the interest and dividends—that is, if it eats into principal—the extra amount is taxed as a capital gain until, year after year, the capital gains tax is paid in full.
Despite the flexibility and tax advantages, charitable remainder trusts have administrative costs. “You have to pay a trustee to oversee it. You might need someone else to make investment decisions. You need someone to file tax returns. And you have the legal fees associated with setting it up,” says Scott M. Kellett, executive vice president at Sabadell Bank & Trust, based in Naples, Fla. “These are not paid out of the trust. These fees are borne by the donor.”
Charitable Gift Annuities
So another good option is the charitable gift annuity. It’s not a trust, but a contractual arrangement between donor and charity. “The charity receives the asset and typically sells it right away to purchase an annuity for the donor,” says Baum. “The donor gets the charitable tax deduction and also likely a higher income stream than he or she would have otherwise, because the annuity is generated off the full value of the asset, without the capital gains tax taken out. Charities don’t have to pay capital gains taxes.”
Unlike with a charitable remainder trust, though, there is no flexibility about the annuity amount. “It’s a guaranteed fixed sum for the life of one or more beneficiaries, calculated on their ages and other actuarial data,” he says.
The income from the annuity is taxable as ordinary income.
Though charities generally prefer liquid assets for this type of arrangement, there are exceptions. Dave Richmond, president of retirement consulting firm Richmond Brothers in Jackson, Mich., had an elderly client with a $3 million home on the shores of Lake Michigan. He also had a favorite charity—a large university. “His kids didn’t want or need the property, so he was going to give it to the university after his death. But he also wanted more income for his final years,” Richmond says.
The university agreed to buy him an annuity without taking immediate possession of the property. “It had enough cash on hand to do that,” says Richmond. “It knew it would only have to wait 10 or 15 years for the house. It might not have been as good an annuity as it would’ve been if they’d been able to take the property right away, and provisions were made to ensure the property was maintained. They worked outside the box, and it turned out well for all concerned.”
Perhaps the biggest drawback of a charitable gift annuity is that it’s a binding contract. “There is no do-over,” says Kellett, of Sabadell Bank & Trust.
Pooled Income Funds
A third option is a charitable pooled income fund. “It accepts gifts from multiple donors,” says Hobart, the advisor in Charlotte. As with a mutual fund, donors receive their representative shares of the income generated by the fund, which will fluctuate. “At the end of the term, or lifetime of the donor, his or her shares pass to the designated charity,” says Hobart.
Administrative costs are shared, too. “Institutions set these up, without promising a specific annuity amount to any donor,” says Hobart. “The institutions invest the funds as they see fit.”
A good example is the pooled income fund run by Fidelity Charitable. “The charitable beneficiary is Fidelity Charitable, from which the donor can recommend grants to their favorite charities, and of course the fund promises professional management. It can be set up in the donor’s high-earning years. The assets can grow tax-free, and the distributions are made over time providing an income stream for the beneficiary,” says Amy Danforth, a senior vice president at Boston-based Fidelity Charitable.
A Role For The Heirs
With any of these options, the only problem might be children or grandchildren who feel cheated. Gagne, the Million Dollar Round Table member in Exeter, N.H., recommends forming a separate wealth replacement trust that’s “funded with life insurance. … The insurance is paid for from a portion of the income generated by the charitable remainder trust,” he says. “What’s great about this option is that the life insurance proceeds will go to the family upon the death of the donor, free from taxes.”
Another idea is to get children involved in the charitable giving strategy. David Skid, a senior vice president at Morgan Stanley’s Vantage Wealth Management Group in Atlanta, suggests letting children become co-trustees. This, he says, gives them “a voice in who the charitable beneficiaries will be and a hand in the investment decisions.”
Yet another possibility is a charitable lead trust. “It basically works in reverse of a charitable remainder trust,” says Skid. “The charity gets its payout up front for a specific period,” he says. (Fifteen years is typical.) After that, whatever remains goes to any beneficiary the donor designates.