For high-net-worth clients, there are a number of issues to consider regarding the distribution of their assets – both for themselves during retirement and for heirs or charities after they pass away. One strategy you can mention that can help address both goals is a charitable remainder trust (CRT).
When set up properly and administered, a CRT can do all of these things: Benefit your client’s favorite charity. Provide your clients with income for life, or for a set term of years. Give your client an income-tax charitable deduction (up to certain limits) for the value of the remainder interest that goes to the charity. Defer your client’s capital gains tax on the transfer of an appreciated capital asset to the trust. Change an illiquid asset (i.e., one that is not easy to sell) into a diversified portfolio without immediate tax consequences. Reduce your client’s estate tax bill (if they have an estate over the federal (and state, if applicable) estate tax exemption amount).
If your client could benefit from most or all of these features, this type of trust may be appropriate for them. Clients should always discuss this charitable strategy with their own tax and legal advisors. There are some general rules that apply to CRTs, and a CRT may not be appropriate for everybody.
Financial advisors should be sure to communicate with their client that there are costs to using this strategy. To fund the CRT, they must give substantial assets irrevocably to the trust. That means those assets will not be available to them should their situation change. There will also be attorney’s fees to set up the trust, along with annual administration fees to operate the trust. If all of a client’s assets go to the charity, their heirs could be disinherited. Also, beware of transferring assets to a charity with a buyer waiting in the wings – the “pre-arranged sale” could prevent a charitable tax deduction and impose capital gains taxes on the client.
How A CRT Works
1. Your client first adopts an irrevocable CRT in accordance with their estate planning attorney’s advice. They can choose a CRT that pays them income for life or for a term of up to 20 years.
2. Your client irrevocably transfers assets to the charitable remainder trust. Generally, a good choice of assets is a “low-basis” (i.e., low original cost) capital asset – for example, a piece of real estate that has appreciated in value and is not a primary residence.
Tax advantages: Your client doesn’t have to pay capital gains tax upon the transfer of the property to the CRT. The property is removed from their taxable estate, which can lower their federal estate taxes if the value of their estate is otherwise over the federal estate tax exemption. And they’ll get an income-tax charitable deduction (up to certain limits) that year, based on the estimated value of what the charity will receive when the trust ends.
3. The trustee of the CRT can sell the asset and reinvest in an income-generating portfolio.
4. The trustee pays a specified income to your client for life, or for the set term of years. At the end of each year, the CRT will report these payments to the client on a K-1 statement, and they may have to report the income on their tax return. Each payment to them is taxed under a 4-tier scheme:
Ordinary income – Tier 1 is the first money out; this is the CRT’s ordinary income, and is taxed as ordinary income to the distributee(s).
Capital gains (realized) – Tier 2 is the second money out; this is the CRT’s capital gains, and is taxed as capital gain to them. Here is where they will pay the capital gains tax from when the CRT sold the illiquid asset they donated.
Tax-exempt income – Tier 3 is tax-exempt income if the CRT holds any municipal bonds.
Tax-free basis – Tier 4 is tax-free return of basis.
5. When the trust ends at your client’s death or after the term of years, the CRT distributes all of the remaining assets to the charity they designated in the trust. They do not have to include the value of the CRT in their taxable estate.
Two Kinds Of CRTs
Charitable Remainder Unitrust (CRUT)
A CRUT promises to pay your client a set percentage of assets from the trust as they are valued each year. The payment will therefore go up if the value of the assets increases, or go down if the value of the assets decreases.
Because additional contributions are possible and the payments can increase as assets increase – and thus provide an inflation hedge – the CRUT is far more popular than its alternative, the Charitable Remainder Annuity Trust (CRAT).
If your client has a less immediate need for income – for example, if they’re more interested in income after retirement – they could consider a net income with make-up CRUT, also called a NIMCRUT. With a NIMCRUT, each year they’re paid the lesser of trust income or a fixed percentage of the annual value of trust assets. In later years, the NIMCRUT can pay them more to make up for any income shortfalls of earlier years.
Charitable Remainder Annuity Trust (CRAT)
A CRAT promises to pay your client a flat dollar amount each year for life or a term of years (not exceeding 20 years). Since no additional contributions are permitted and payments are a flat dollar amount, there is no opportunity for increased payments as asset values rise.
Under IRS rules, your client is limited on the percentage of income they can choose in a CRUT or a CRAT. This is to ensure that the trust won’t be completely depleted by payments back to them, and that there will be something left for charity. However, their income rate must be at least 5% and no more than 50%, annually.
Turning Income Off Or On
If the trust document allows, a charitable remainder trust can purchase a nonqualified deferred annuity. The provisions of the annuity should be checked carefully in relation to the goals and retirements of the CRT. The CRT would own the annuity and all annuity withdrawals would go to the CRT, not directly to your client. However, the CRT can use these funds (alone or with funds from other investments) to make the payments to them. The best approach is to avoid having the annuity the sole asset in the CRT.
If your client wants to delay income from the trust until they retire, by choosing a net income with make-up CRUT (NIMCRUT) that’s funded with a nonqualified deferred annuity, the trustee can control the timing and amount of the income distribution to them.
In this case, the trustee does not withdraw funds from the annuity, so the NIMCRUT does not have income to distribute to them. Instead, the trustee keeps track of the amounts it has not paid out (based on the set yearly percentage) in a “make-up” account.
When your client is retired and ready for NIMCRUT income, the trustee takes annuity partial withdrawals based on the trust’s income payment rate, and also pays your clients funds from the make-up account.
It’s best that the trustee of a CRT does not rely only on an annuity to make the income payments to your client. That’s because a time could come when the allowed annuity withdrawal falls short of the income payment promised to them. If that’s the case, the CRT trustee might incur a surrender charge to withdraw enough to make the payment. In addition, the CRT could fail to qualify under IRS rules if there is nothing left in the CRT to give to the charity. To avoid this, it helps to have other assets in the CRT besides the annuity to make the income payment. Also, it is important for the trustee to understand how the various withdrawal options in an annuity contract operate, including why annuitization payments may not work well for a charitable trust.
Although there are simpler and less expensive ways for your high-net-worth clients to benefit their favorite charity, using a charitable remainder trust is an effect way for them to transfer assets to that charity while still receiving lifetime income from those assets. If they are interested in this strategy, advise your clients to find out more by asking their estate-planning attorney and tax advisor.
Deb Repya, JD, CLU, ChFC, is vice president of Advanced Markets for Allianz Life. In this role she is responsible for the strategic direction of the Advanced Markets group and also oversees the development, promotion and quality of the group's services. Allianz Life Insurance Company of North America offers insurance and annuities in all states except New York. In New York, products are issued by Allianz Life Insurance Company of New York.