For philanthropically minded investors hoping to minimize taxes, a charitable remainder trust (CRT) allows donors (a.k.a. grantors) to make a tax-deductible gift to charity while also generating income for themselves or their heirs. This strategy is especially useful for investors looking to reduce or defer the capital gains taxes on highly appreciated assets, such as stock, real estate, or a closely held business.
How CRTs work
Here's a look at the life cycle of a CRT:
- You transfer appreciated assets or property to an irrevocable CRT and receive a tax deduction for the year in which the donation was made (see "Taxes and CRTs").
- A designated trustee (appointed by you) sells the assets, paying no capital gains, and reinvests the proceeds.
- The trustee pays you or another noncharitable beneficiary an income for a set number of years or for life. (Note: If the noncharitable beneficiary is anyone other than you or your spouse, gift taxes may apply.)
- At the end of the trust's term, the remaining assets go to one or more chosen charities.
Types of CRTs
The two primary types of CRTs to consider are a charitable remainder annuity trust (CRAT) and a charitable remainder unitrust (CRUT). While both must provide annual payouts of no less than 5% and no more than 50% of the trust's assets, they are valued differently:
- A CRAT is valued upon creation and does not allow additional contributions following the initial setup. The beneficiary receives either a fixed dollar amount or a fixed percentage for a set time—but no longer than 20 years.
- A CRUT is revalued at the end of each year to determine the fair market value of its assets—of which the beneficiary receives a percentage annually. Therefore, the trust's assets could produce less income during a down market, but additional contributions are allowed.
As with most trusts, there are costs for trust creation and maintenance.
Taxes and CRTs
Donating to charities via a CRT allows you to potentially save on taxes in at least three ways:
1. Income tax charitable deduction: Upon formation of the trust, you can generally take an immediate charitable deduction for the "remainder interest," which is a rough calculation of what will remain of your original donation after your annuities have been paid out. The remainder interest—which helps offset the income tax on annual distributions—can be calculated using the duration of the trust, along with:
For example, let's say a 60-year-old widow in the top tax bracket owns an investment property with a fair market value of $1 million and a cost basis of $250,000: If she sells the property, she'll owe $178,500 in taxes ($750,000 x her capital gains rate of 23.8%).
On the other hand, if she transfers the property to a CRAT that then sells it, she could receive a $50,000 annuity (5% of the trust's value at creation) for 20 years and also receive an income tax deduction on the charitable portion of the trust. To calculate the charitable deduction:
- First, cross-reference the IRS' Section 7520 rate in the month you create the trust (let's say August 2022, so 3.8%) and the annuity term (20 years) to determine the present value factor in the IRS' actuarial Table B: 13.8342.
- Second, multiply the annuity amount by the present value factor to determine the value of the annuity: $50,000 x 13.8342 = $691,710.
- Finally, subtract the value of the annuity from the value of the CRAT assets to determine the value of the charitable deduction: $1,000,000 – $691,710 = $308,290.
2. Estate tax reduction: As an irrevocable trust, a CRT subtracts any donated assets from your taxable estate.
3. Tax-exempt status: As a fully charitable entity, a CRT pays no income tax on investment income, including the sale of appreciated assets.
Maximizing your CRT
In addition to its tax benefits and income stream, a CRT can be combined with other strategies that have their own benefits. For example, you could:
- Name a donor-advised fund (DAF) as the CRT's charitable beneficiary: With this strategy, you get the immediate tax benefits of the CRT but can advise how the charitable dollars are invested, as well as control the amount, beneficiaries, and timing of the distributions to charity.
- Designate the CRT as beneficiary of an IRA: If your noncharitable beneficiary is someone other than you or your spouse, and you'd like to leave that same beneficiary an IRA account, make your CRT the beneficiary of your IRA to prolong the distribution of its assets to your designated beneficiary, who would otherwise have 10 years to distribute those assets under SECURE Act rules.
- Combine your CRT with a life insurance policy: This combination creates a wealth replacement strategy in which you (as the grantor) use the income from the CRT to purchase a life insurance policy and place it in an irrevocable life insurance trust. When you pass, your heirs receive the death benefit of the insurance policy—free of income and estate taxes—which offsets the loss of the assets donated to fund the CRT.
Although CRTs are a powerful estate-planning tool, you should work with a qualified estate-planning attorney and tax advisor to make certain you're aware of all the potential tax consequences and to ensure the proper administration of the trust.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.1122-2XNK