By Dr. James M. Dahle, WCI Founder
This post is all about CRATs, CRUTs, CLATs and CLUTs. These acronyms all relate to “split-interest gifts” or “charitable trusts.” In essence, these are a way to donate some money to charity while reaping some other benefits, usually tax benefits.
Charitable Trust Term Definitions
Let's go through them one by one. But first, let's define some terms.
Split Interest Gifts
A split interest gift is when the income from the gift goes to one place, and the principal of the gift goes somewhere else. For example, the income may go to you, your heirs, or the charity, and then after a certain period of time (or after a certain event) the principal goes to your heirs or the charity. Thus, the income and the principal are “split.” This splitting of the interest is what allows for all kinds of interesting benefits you may be interested in.
Unitrusts vs Annuity Trusts
The UT in the acronyms stands for “UniTrust.” The AT stands for “Annuity Trust.” With a Unitrust, the income payments vary with how well the investments in the trust are doing. If the investments are doing well, the payments are high and vice versa. With an Annuity Trust, the payments are fixed, no matter how the investments are doing. Annuity payments are based on a percentage of the ORIGINAL amount in the trust. Unitrust payments are based on a percentage of the CURRENT amount in the trust. If you think the investments in the trust will do well, go with a unitrust. If you have less faith in them, use an annuity trust.
Lead vs Remainder
The C in all these acronyms stands for charitable. The L stands for “Lead” and the R stands for “Remainder.” This refers to what the charity gets. If the charity gets the income, it's a lead. If the charity gets the principal, it's a remainder. In times of high interest rates, the remainder trusts are better for the giver since he gets paid a higher rate. In times of low interest rates, the lead trusts are better for the giver's heirs, since the charity gets paid at a lower rate.
CRATs and CRUTs
A charitable remainder annuity trust (CRAT) may not require you to be all that charitable in order to work out well. Consider Bob and Jody Smith, both 75 years old, who have a 23.8% capital gains rate, a 45% marginal tax rate, and $500K in appreciated shares with a basis of just $100K. If they decided to use a CRAT, it would pay them 5.7%, or $28,500 per year. They would get a charitable donation deduction of $146K, saving them $65,700. They would also save $95,200 in capital gains taxes. So here's what they get:
- A smaller estate, possibly reducing estate taxes due
- The ability to eliminate investment risk/rebalance without incurring capital gains taxes (imagine if the donation didn't consist of the shares of an broadly diversified index fund, but rather $500K of shares in a single company
- $95,200 break in capital gains taxes
- $65,700 break in income taxes (limited to 30% of AGI for private foundations and 50% for churches, hospitals, schools, and government entities, but can be carried over for 5 years)
- $28,500 per year for the rest of both of their lives
- Good feelings from supporting their favorite charity
Would they be better off just selling off the shares and buying an annuity? Probably not in this case. If they sold them they would lose the $65,700 deduction plus have to pay $95,200 in capital gains taxes, leaving just $339,100. A joint annuity on two 75 year olds pays 6.9%. Sure, that's more than the 5.7% the CRAT is paying, but keep in mind the CRAT is paying 5.7% on $500K, not $339K. In reality, the joint annuity would have to pay 8.4% to be as good as the CRAT. See what I mean about not having to be very charitable for this to work out well? Keep in mind that given our very low interest rate environment, you may not be able to get one of these if you're too young due to IRS rules about the remainder going to the charity being at least 10% of the amount going into the trust.
If Bob and Jody decided to use a CRUT instead, they have to choose a withdrawal rate between 5% and 10%. What's the downside of choosing 10%? Well, with a higher rate they'll end up leaving less to charity. This is reflected in the size of their initial charitable donation deduction of just $128K ($58K off their taxes). Also, if the trust isn't actually growing at a rate of 10% or higher, their payments will actually go down over time. But they do get to at least start with payments of $50K per year. If they choose 5% instead, their annual payment will start at just $25,000, however the payments are far more likely to go up over time (or at least not go down as fast.) Plus, they'll get a much larger initial charitable donation deduction, $246K ($111K off their taxes).
CLATs and CLUTs
Lead trusts can also be useful, especially in times of low interest rates. They are particularly useful for reducing estate taxes owed. By giving annual payments to charity for a set period of time (rather than the rest of your life), you can give the principle to your heirs free of estate taxes. Typically a term of between 5 and 25 years is selected and rates are typically between 5% and 15%. The longer the term and the higher the rate, the larger the charitable deduction (and the smaller the amount your heirs will get.)
If Bob and Jody choose a CLAT with a rate of 5% ($25K per year) for 10 years, they will give the charity $250K total and will get a charitable donation deduction of $222K. Whatever is left, goes to their heirs ($278K of which would be subject to estate taxes.) If the trust made 8% a year for those 10 years, the heirs would get $672K, the charity would get $250K, Bob and Jody would save $100K in income taxes, and the IRS may not get squat. Even if the trust only made 5%, the heirs would still get $500K.
If they chose to use a CLUT instead, with the same 5% rate and 10 year term, the deduction would be smaller, just $197K ($89K off their income taxes). The better the investments do, the more the charity gets each year and the more your heirs get in the end.
Charitable Annuities
A charitable annuity is another option, similar to a CRAT, but can usually be done more cost-effectively for a smaller amount of money (less than $100K-$1 Million). However, the charity usually makes out a little better (and thus your charitable deduction donation is larger.) Using the same example with Bob and Jody Smith donating $500,000 above, the rate suggested by the American Council on Gift Annuities for their ages is 5.0%. So they would get payments of $25,000 every year until they died. Their donation would be about 50% deductible, reducing their taxes by $112,500, and of course getting the entire $500,000 out of their estate for estate tax purposes.
Other Options for Donating to Charity
There are several other unique options for donating to charity. A pooled income fund is like a charitable annuity except the payments to the donor are variable and lower. However, the charity gets more and you thus get a higher charitable donation deduction.
Charitable life insurance is another option. With this you give an annual donation to a charity which uses the donation to pay the premium on a permanent life insurance policy on you. Each year you get to write off this donation and feel good about your giving (and maybe even get a building named after you.) When you keel over, the charity gets a large sum of money that can be used to build a building, endow a chair, or whatever.
You can even combine a charitable gift with a spendthrift trust. Upon your death, your money goes into a charitable trust. The money is out of the estate (avoiding estate taxes) and a certain amount of it (depending on the age of the spendthrift and current interest rates) is a deduction on the estate's income taxes that year. The spendthrift gets an annuity payment every year for the rest of his life. You can even set it up so the spendthrift heir gets to pick the charity.
What do you think? Has anyone in your family used a charitable trust, a charitable annuity or one of these other options? How did it work out? Do you plan to give to charity using one of these methods? Why or why not? Comment below!
Tried to make sense of this, but it went over my head. Reader’s Digest version: which do you anticipate using? Going back to square one, is a trust just another account set up at any bank with specific rules?
I don’t anticipate using any of them at this time. I give to charity directly as I go along. But who knows what will come along in a few decades. Charitable trusts are designed to solve first world problems! Chances are most docs don’t NEED one of these, but depending on your desires, they may be useful.
Thank you for the clarification. I can exhale now.
Regarding future site changes, a “star rating” review of the post: (a) experience level, (b) usefulness.
I like how you mix up the content but it is confusing sometimes to prioritize the importance level of it.
Lots of optional stuff in finance-cash value life insurance and charitable trusts for instance. It might be helpful with some niche needs, but certainly not “required.”
I’m not sure I want to mark my posts with a “this is useless” indicator. 🙂 But I do try to have both basic and advanced material available.
Haha. I meant that the readers could leave a star rating as to “helpfulness”. [Amazon has the “Did you find this helpful?” question]
I really appreciate how you have organized the levels of complexity of old posts on the Getting Started page. Keeping that going with new posts gives a heads-up that what we’re reading may be a bit over our head (which is great!).
If you keep reading, nothing on this blog will be over your head for long. But good idea. I’ll look into incorporating it into the new design.
It seems like for most physicians and mud-high earners it may be more practical to use a DAF or “Donor Advised Fund”; do you agree WCI? What scenarios other than extremely high net worth would the above apply?
I disagree that a DAF is always the better choice. It should be considered, of course, but a DAF is essentially just a way to get a tax deduction now, just like donating to charity this year. There is no possibility of income from it.
Fantastic post…wish I understood what you were saying. It may be a little easier to follow if the examples show comparisons of where each dollar goes under different scenarios, ie: appreciated stock donated directly to charity now or at time of death, donate a portion of the stock each year, etc. It may also help if it explained when each scenario is best. Ie: I want to donate approximately $100,000 to charity for the next 5 years, rest of my life, etc; I want to maximize my tax deduction now, but give the assets over the next 20 years; I want to reduce my estate size, but my kids get a certain size for their inheritance; I want to make sure I have a steady income for the next 30 years, but then the remainder goes to charity when I die, etc.
I can see the guts of the different plans, I just don’t know what animal they’re coming from.
Well, this is one of those things where there are dozens of different ways to do it. Like with anything in finance, it is best to start with your goals, then look at the best way to achieve them. With regard to charitable trusts, the usual goals are to give as much as possible and/or spend as much as possible while cutting out the tax man.
Nice post. Learned something new today.
It wasn’t clear to me how the deductions were calculated. I presume it is an actuarial table in some part of the IRS code, correct?
Looks like a decent option for decent size estate and/or those looking at SPI Annunities.
Great topic! I hope to have a trust rolling some day, though the one doc I know who set up a trust was quite negative about the paperwork and IRS hurdles. His was a charitable trust for a niche interest/charity.
I think I’m following you through the definitions, but Bob and Jody confused me. In very simple terms:
Bob and Jody have high marginal tax rates. They own shares of some type. The total value of the shares is $500k, appreciated from a basis of $100k. This means they would pay a lot in taxes on that $500k.
Being WCI readers, Bob and Jody decide to set up a trust… with the whole $500k? And after some calculations, they end up with a tax deduction of $146k. In the case of the CRAT, the charity gets the principal ($500k, payable on defined event) but Bob and Jody get yearly payments from the investment returns.
As thoughtful people, Bob and Jody also test drive variations on trusts, but they always start with a $500k investment. Each investment results in a different tax deduction. That makes sense, because the principal, withdrawal percentages and recipients vary across the trust types.
Does that sound about right?
Seems like a good summary.
Via email from “Ron”:
If you plan on leaving money to charity, a CRUT can be a great way to save on taxes. Just prior to the sale of my practice and building, the building and equipment was put in a CRUT. This saved about $100,000 in taxes. Also, the payback rate was determined by a lawyer and actuary well versed in CRUTS. The max payout was determined to be 7.7% based on my wife’s and my ages (early 50’s at the time). At max payout rate the total charitable contribution would be recouped in 14 years. The payout max is a limit set by the actuary based on our ages when this was set up. If the investments earn less than 7.7% then the payout is less and it will take more time to recoup the total. At current rates it will probably take around 20 years to recoup the total but this was set up when I was 54 so we should still recoup the total by our early 70’s.
This is a great way to shelter some profit from a practice sale. It is also a great way to provide for a surviving spouse should something happen to one of you. Just be careful to have an attorney who specializes in these to make sure you have properly jumped through all the IRS hoops. The charity can also be named later if you have worries about changing ideas of which charity to give to. I have a CRUT investment account and control the investments.
Cost to set this up was approx. $7k . Yearly IRS return and payout calculations done by trust administrator cost ~$800/year.