A charitable remainder trust is a specially designed tax-exempt irrevocable living trust set up to host and hold appreciating assets, pay out income to its beneficiaries, and eventually donate the remainder of its contents to a charity of your choice.
While the focus of a charitable remainder trust seems to be the giving to charity, it is primarily designed to avoid giving to the tax man.
The central role of a charitable remainder trust is to reduce your tax liability by holding assets in an irrevocable trust. This irrevocable trust cannot be terminated or modified without the beneficiary’s permission, effectively cutting off the trustor or grantor (you) from any ownership rights.
Let’s explore exactly how that works.
A charitable remainder trust is an irrevocable living trust. Trusts themselves are legal entities defined by a trust document, and funded by a trustor, or grantor. This is the trust’s creator. Most trusts are managed by a trustee in the grantor’s absence, and eventually make payouts to a beneficiary. This three-way relationship is the basis of every trust.
Living trusts are trusts that become active while the grantor is still alive, as opposed to testamentary trusts, which are only activated and funded upon the grantor’s death.
Irrevocable trusts are nearly ironclad and cannot be changed, creating a stronger degree of separation from the grantor and the contents of the trust. Revocable trusts, on the other hand, still count as under the grantor’s control, and can count towards their estate’s total value. They can also be more easily modified and changed, as well as revoked.
In a charitable remainder trust, the charity is the trustee, as well as the ultimate benefactor of the trust’s remainder after a set period. So, why place your assets in a separate legal entity? To minimize your income taxes now, and your estate tax when you pass away.
A charitable remainder trust is set up to ultimately pay out the remainder of its contents to charity. However, for the majority of its duration, it receives contributions from its grantor and pays out income to its beneficiaries.
Despite this, setting up a charitable remainder trust qualifies you for a charitable income tax deduction. This is the first palpable tax benefit a charitable remainder trust affords you.
Next, the trust must be funded. A good method for doing so is funding it with appreciated assets. These are assets that have already gone up significantly in value, far more than when you first purchased them.
Transferring them into your charitable remainder trust rather than selling them yourself allows you to avoid reducing their value through capital gains taxes. Instead, the trust receives the appreciated assets at their new base value, and sells them for full market price, reinvesting all the proceeds into other income-producing assets, or appreciating assets. Common examples range from stocks and shares to rental properties.
For a set period – from a few years to the rest of your life – your charitable remainder trust will continue to pay out income to a beneficiary of your choice (including yourself) until the trust’s term is complete, at which point the charity acting as trustee of the trust receives the remainder of its contents (also known as the principal).
To recap, a charitable remainder trust allows you to benefit fully from the appreciated value of an asset that has had time to grow without forcing you to pay more taxes on it, all while making a significant contribution to a cause of your choice.
Furthermore, it provides you with an income tax break for a charitable contribution, while protecting your assets from creditors, and providing greater annual income due to the lack of capital gains taxes.
If you sell an appreciated asset and take the hit on capital gains taxes, you have less money to reinvest into a new appreciating asset. Even with the same annual expected return on investment, you would earn far less income from your new assets than if you had been able to reinvest the entire market value of the appreciated asset. And you’d be missing out on the income tax deduction.
Charitable remainder trusts can be set up to pay out trust income to yourself or your spouse for as long as you live, or to a benefactor of your choice (your children, for example) for a set number of years up to twenty.
Once a charitable remainder trust is set up, it will pay out income in either one of two ways – as a charitable remainder annuity trust, or as a charitable remainder unitrust.
A charitable remainder annuity trust distributes a fixed annuity each year. Charitable remainder annuity trusts do not allow for additional contributions. The main benefit of setting up a trust this way is that you receive the same income each year, regardless of the performance of the assets in your trust. Annuity trusts are best funded with cash from the proceeds of an appreciated asset, or an easily marketable asset (assets that can be quickly liquidated, such as stock and certain financial instruments).
A charitable remainder unitrust distributes a fixed annual percentage based on the balance of the trust’s assets. Charitable remainder unitrusts allow for additional contributions. The benefits of a unitrust include better returns, especially as the assets in the trust perform better.
This allows your annual income to beat inflation, for example. On the other hand, a unitrust may also have a bad year. Your income will fluctuate based on the performance of the assets in the trust. The trust will be revalued at the beginning of each year to determine what your actual pay-out will be. One of the central benefits to a unitrust is that it is easier to grow, by making regular contributions to it as the trust’s grantor.
Charitable remainder trusts are a great idea if:
It’s best to discuss these ideas with a certified financial planner or estate planning expert before setting any plans into motion.
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