Big Picture with Charitable Remainder Trusts

Before I get immersed in the details, the big picture that I’m presenting in this post is that there are many situations where your children would get more money and a steadier income if you named a charitable remainder trust as the beneficiary of your IRA than if you named your children directly. If you have a million dollars or more in your IRA, even if you aren’t very charitable, you should at least consider naming a charitable remainder trust as the beneficiary of your IRA.

What is a Charitable Remainder Trust?

First of all, when I say a charitable remainder trust, what am I talking about?

In this context, I am talking about naming a trust as the beneficiary of your IRA or retirement plan. Of course, if you are married, you would name your surviving spouse as the primary beneficiary. In this post, I will compare naming your children as the contingent beneficiary after your spouse (or your children if you don’t have a spouse you are providing for) to naming a charitable remainder trust.

To oversimplify, the trust would provide your beneficiary (let’s assume your child) with a distribution that has some, but not a complete correlation to the income of the trust, and then at the child’s death the amount remaining in the trust would go to the charity of your or even your child’s choice. Actuarially, the charitable remainder trust must be set up in a way that the charity receives 10% of the present value of the bequest at the date of death but that leaves 90% for your children. When you take into the enormous tax benefits of the charitable remainder trust and the draconian tax treatment of leaving your IRA to your children directly, your children often get more value, sometimes by hundreds of thousands of dollars, than if you just leave the IRA outright to them.

Below I present the very favorable math of the charitable trust for your family. Having charity in your heart is a major bonus. If you like the idea of maintaining a significant amount of money in the tax deferred environment and having your beneficiary get regular distributions for the rest of his or her life, especially if it results in more money for your children, then charitable remainder trusts should at least be considered.

The charitable remainder trust can to some extent be treated as a stretch IRA.

To get the best results, leaving your IRA to someone other than your spouse requires strategic planning. Let’s go back to exempt beneficiaries. In addition to your spouse, charities and charitable trusts are also exempt from the 10-year tax acceleration rule. To utilize this exemption to the 10-year tax acceleration rule, you could establish a Charitable Remainder Unitrust (CRUT), or Charitable Remainder Annuity Trust (CRAT) and name it as the beneficiary of your IRA (after naming your spouse as the primary beneficiary assuming you are married).

So, to be clear, this trust is a testamentary trust meaning that it isn’t funded before you and your spouse die. While you and/or your spouse is alive, there is no tax return, no money goes into it, and other than some paper sitting in a fireproof drawer, it doesn’t exist. It is totally revocable meaning you can change it as long as you and/or your spouse is alive. But, after you and your spouse die, if you name it as the beneficiary of your IRA or retirement plan, it becomes irrevocable and the trust comes to life.

Here’s how a CRUT (or a CRAT with minor differences) works at the basic level. When you die or when both you and your spouse are dead, what remains, or a portion of your IRA could be transferred to a CRUT and the IRA can then be liquidated without paying taxes.

The conventional approach would be to leave your IRA directly to your children and/or grandchildren and all of it will be taxed in 10 years. With a CRUT, your children won’t get a lump sum of money when you die, but they also will not face a big tax bill immediately after you die or as big of a tax bill even 10 years after you die. They would receive a regular “income” from the CRUT for the rest of their lives. The distribution would be treated as ordinary income until the amount of the initial IRA plus any interest and dividends earned in the CRUT has been paid to your child. After the ordinary income has been distributed, then capital gains would be distributed. Finally, when your children die, whatever is left in the CRUT goes to the charity of your or their choice.

Although you probably have some charity in your heart, you would most likely rather see your children get the bulk of your money rather than your favorite charity. Me too. The reason that this is an idea worth considering is that the money that goes into the CRUT in this case, your IRA isn’t subject to the new rules governing after-death IRA distributions.

A CRUT, since it is an exempt beneficiary, can mimic the benefits of the stretch IRA by paying out the IRA income over a period of more than ten years and providing your heirs with a steady income over their entire lifetimes. Distributions from a CRUT can be stretched and taxed over your child’s life (if you have no spouse) or after the deaths of you and your spouse. I like to look at everyone’s unique situation and I like to do the math.

Disadvantages of a CRUT

• You need to have an attorney draft the CRUT.
• You need to name a trustee.
• You can expect to pay an additional $500 to $2,000 or sometimes more every year for the remainder of the beneficiary’s life, to maintain the trust from a legal and tax compliance standpoint. You not only need to file a special CRUT tax return, but you also must file a K-1 with the beneficiary which complicates his return. The additional complication and aggravation of drafting and more importantly maintaining the charitable trust for the life of your child or children should not be underestimated.
• The trustee of the CRUT is required to report the income that the beneficiary receives to the IRS and must send to each beneficiary a form called a K-1 which complicates the beneficiary’s own tax return. If your beneficiary lives for 20 years, it’s not unrealistic to think that the fees required to maintain the trust could exceed $20,000 or even $40,000.
• Ultimately you could be creating significant complications for less tax savings than you would have realized if you had just left the money to your child instead of the CRUT.
• If you leave your IRA to a CRUT, it could potentially hurt your family. If the income beneficiary of the trust (most likely, your child) dies prematurely, the remaining balance will go to the named charity and not to your grandchild like it would if you just left the IRA to your child. So, there is a very real risk with a CRUT, and it would likely not be a good choice if your beneficiary has a reduced life expectancy. The answer to that objection is to buy a term life insurance policy on the income beneficiary with a trust for his or her child or children as the beneficiary of the policy.

Advantages of a CRUT

• Including a CRUT as part of your estate plan may make an enormous difference for the long-term security of your child or children and it may be the best way to maximize the number of dollars your child receives. If you have charity in your heart as well as protecting your family, it may be a wonderful thing.

Let’s compare leaving your million-dollar IRA to a CRUT versus leaving it to your child. What is the best option for the $1 million dollars if she will have to pay income taxes on the entire million (plus growth) within 10 years of your death? Though I could do some post-mortem planning, it will be extremely difficult to protect that distribution from very high tax rates that are projected to get even higher in the future.

To oversimplify, the tax on the $1 million Inherited IRA could be $400,000 leaving your child with net proceeds after taxes of $600,000 plus appreciation.

On the other hand, the CRUT pays no income taxes when you die. So, the income that your child will receive is based on $1 million, not $600,000. What I will show below is that your child may be able to get more money over their lifetime as the beneficiary of a CRUT than if she receives your $1 million IRA outright.

Let’s look at an example. Suppose Alice creates a CRUT that names Roberta as the income beneficiary, and her favorite charity (or charities) as the remainder beneficiary. She stipulates that $1 million of her IRA will be transferred to the trust at her death. Roberta won’t inherit the IRA directly, but she will receive a nice check from the CRUT on a regular basis for her entire life. The amount that she receives is calculated yearly according to a complex formula required by the IRS because there is a minimum amount that must eventually be turned over to the charity in order to get this favorable treatment.

So, which inheritance will benefit Roberta the most, the money outright subject to accelerated taxes or the income from the CRUT? The answer is it depends on what interest rates you assume but perhaps more importantly, and how long Roberta lives.

Given certain reasonable assumptions, Roberta would have $400,331 more money if her aunt left her IRA to a charitable trust compared to leaving it outright to Roberta.

Roberta only has to live past the age of 63 to receive more money from the CRUT as compared to inheriting the $1 million IRA stretched over ten years. (The breakeven point may change depending on your circumstances, what assumptions you use, the Section 7520 rate when the CRUT is created and how old your beneficiary is at your death.) The other advantage of the CRUT is that she will have all the protections of a trust including protection from creditors, protection from herself, and in some cases, financial protection from her husband should she divorce or the marriage survives and her husband has different ideas on how she should spend her money. In addition, the charity would get $1,221,929 after Roberta dies.

Key Ideas

• In many situations it will make more sense to leave your IRA to a charitable trust than to leave it to your children directly. It is possible, even likely, your children will actually end up with more money than if you left the IRA to a charitable trust than if you left it to them outright
• After the SECURE Act many IRA owners that never had a good reason to closely look at a charitable remainder trust as the beneficiary of their IRA should now consider one.