What if you could sell off a highly appreciated asset, avoid capital gains taxes and create a steady stream of retirement income for yourself or your loved ones? It may sound too good to be true, but those are just a few benefits of establishing a charitable remainder trust (CRT).

Traditionally, trusts are created for estate planning purposes, but some types of trusts can actually provide benefits that you get to experience during your lifetime. One such trust is a CRT—a tax-exempt, irrevocable trust meant to reduce your taxable income. CRTs are becoming increasingly popular because they can potentially reduce your liability for certain taxes, allow you to support your favorite charities and causes, and even create a steady stream of retirement income.

How Do Charitable Remainder Trusts Work?

A charitable remainder trust is a type of "split-interest" giving vehicle. The assets in the trust are split between the initial beneficiary (you or someone else you name) and a charitable organization. While there are a couple of different kinds of CRTs, which we explain below, they both generally function the same way.

First, the grantor (the person establishing the trust) contributes assets to the trust. This can be anything from cash to stock shares, property, and even artwork. It's most beneficial to contribute assets that have already greatly appreciated in value to a CRT because the trustee can sell the asset immediately and be subject to no capital gains tax on that sale, then convert the proceeds into other income-generating assets.

After contributing assets, you set the terms of the trust, which comprise three primary components:

• Annual income: This is where you decide how much annual income you want the initial beneficiary to receive from the trust, which must be at least 5% of the fair market value of the assets in the trust, but no more than 50%.
• Trust lifespan determines how long you want the trust to last, which can be any set number of years up to 20 or the remainder of your life.
• Charity remainder: Finally, you decide how much you anticipate donating to the charity/charities of your choice when the trust expires. This must be at least 10% of the trust assets’ fair market value. However, since whatever's left in the trust at the time of expiration is donated to charity, this final dollar amount could be more or less than what you anticipate.

Then, once the assets have been contributed and the terms have been set, the trustee (entity administering the trust) determines the fair market value (FMV) of the assets and essentially takes ownership of them, potentially selling the assets and converting the proceeds into other assets. Every year, the trustee sells off a portion of the assets in the trust to cover your income stream, and the cash from that sale is paid out to you. If the trust allows it, the trustee could make the payment in kind, which means distributing a portion of the assets themselves instead of cash.

Finally, when the trust expires, any remaining funds are transferred to the charity or charities you name as beneficiaries.

Figure 1: Charitable Remainder Trusts Explained

Image

Retirement Income Planning with the Two Types of Charitable Remainder Trusts

There are two main types of CRTs, Charitable Remainder Unitrusts (CRUTs) and Charitable Remainder Annuity Trusts (CRATs). While their basic structures and functions are the same, they have slight variations that can make a big difference in your financial plan.

How Does a Charitable Remainder Unitrust (CRUT) Work?

Charitable remainder trusts are one of the two types of CRTs. With CRUTs, the income stream that the initial beneficiary receives from the trust is a set percentage of the FMV of the remaining trust funds, and the FMV gets revalued every year. This is a huge benefit if you place assets like stocks or properties into the trust because those assets could appreciate over time. If that happens, you could make more money from the trust every year.

For example, let's say you contribute shares of stock worth $300,000 into a CRUT, you name yourself as the beneficiary, and you wish to receive an annual income of 15% of the remaining assets in the CRUT. You'll receive $45,000 of income from the trust in that first year. At the year's end, those shares' FMV is revalued. Let's say the markets are on fire, and the value of your shares jumps up to $350,000. If that happens, you'll receive $52,500 in income from the trust over that second year. However, this appreciation won't be free from capital gains tax upon distribution (more on that later).

CRUTs also allow you to make additional contributions to the trust even after it has been established. This is a great benefit if you have additional highly appreciated assets. You could contribute continuously to your CRUT, generate a more significant income in retirement, and leave more to your favorite charities.

How Does a Charitable Remainder Annuity Trust (CRAT) Work?

The second type of CRT is called the charitable remainder annuity trust. Unlike CRUTs, CRATs pay out a fixed dollar amount yearly—not a percentage. Returning to our previous example, let's say you’re contributing shares of stock worth $300,000 into a CRAT. Instead of choosing to receive 15% annually, you would simply choose to receive $45,000 annually, which you would receive regardless of how that stock is performing.

CRATs make a lot of sense when you want your income to remain consistent—such as if you’re relying on the income from your CRAT as a steady source of money in retirement. Because you do have to pay taxes on the income from your CRAT, maintaining a consistent amount can also give you more control over which tax bracket you’re in. The same can’t be said for CRUTs, which can catapult your annual income into a higher tax bracket if the value of your trust assets increases.

Pros and Cons of Charitable Remainder Trusts

Pros

Establishing a CRT can benefit you, your loved ones and the charities of your choosing.

Mitigating capital gains taxes while planning for the future: Charitable remainder trusts can be an excellent way to avoid the capital gains tax on highly appreciated assets while retaining access to the funds from the sale of those assets. CRTs also provide a steady source of annual income, which you may rely on in retirement. If you don't name yourself as the initial beneficiary, that income stream could be used to benefit a spouse or even your children.

Immediate & flexible philanthropic strategy: If you’re philanthropically inclined, CRTs offer a great way to give back a portion of your estate to the organizations you support. You can take a partial income tax charitable deduction when you fund the trust, which is based on the remaining amount you plan to distribute to the charity of your choice when the trust expires, as well as the trust's terms and IRS interest rates. For example, when the terms of the trust are established, if it appears that you will leave 20% of the trust to charity, you can immediately take a partial income tax charitable deduction on the amount you are expected to donate (in this case, 20% of the FMV of the trust assets, accounting for the trust's term and projected growth of the assets). And because those assets have been removed from your estate, you’ll also lower the estate tax.

Funding a CRT with an IRA: As of 2023, individuals over the age of 70½ can use up to $50,000 from their individual retirement accounts (IRAs) to fund a CRT as a qualified charitable distribution (QCD) without triggering a taxable event. Although there are specific rules to this type of conversion, it provides a new avenue for charitable individuals to give more of their assets to charity while also realizing tax benefits.

Cons

You need to be aware of some potential drawbacks to establishing a CRT.

Irreversible loss of control: By placing assets into the trust, you give up a lot of control relative to if you had divided up the assets via a will or some other method. And since the trust is irrevocable, the terms cannot be altered—once they’re set, they’re set.

Many tax implications: While these types of trusts are technically tax-exempt, they still incur some tax liability. You must pay taxes on the annual income you receive from the trust, which can push you into a higher tax bracket. Additionally, if the trust sells assets that have appreciated while in the trust, you don’t need to realize the capital gain immediately. However, you will be required to pay capital gains taxes on the appreciation whenever a distribution is paid to you. For example, let's say a trust that distributes $10,000 to you each year realizes a capital gain of $100,000 from the sale of a stock in the trust. The first ten payments will be taxed as capital gains until the full $100,000 gain has been distributed, after which the distributions will continue to be taxed at the regular income rate as normal. If the trust realizes ordinary income, this would be distributed before capital gains income, and other income, such as tax-exempt interest, is distributed after capital gains income. This type of distribution structure is also known as "worst-first" or "worst to best." How assets are distributed from your trust can have important implications on your financial plan.

Susceptible to volatility: Finally, if you fund the trust with something that has fluctuating value, like stocks or property, it's possible that the value of those assets could drop over the lifetime of the trust. This could affect how much income you receive from the trust, and it’s even possible that there’s nothing left over to donate to charitable organizations once the trust expires.

Should I Establish a Charitable Remainder Trust?

While there are significant benefits to setting up a CRT, it’s ultimately a decision that will depend on your specific situation. Do you have highly appreciated assets? Do you want to avoid paying capital gains tax on the sale of those assets? Are you charitably inclined? Do you want a steady stream of income in retirement? If you can answer “yes” to those questions, a CRT may be something to consider as a part of your retirement income plan.

Luckily, you don’t have to make that decision alone. By discussing your financial situation with the advisors at Wealth Enhancement Group, you can better understand the options available to you and make strides to ensure your goals are met.

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.