Segment 1: Beware of the Pitfalls SEGMENT BEGINS AT 00:39 Over the years, investor/trading coach Jerry Robinson has encountered several pitfalls that have interfered with achieving financial success. Today he shares five of these pitfalls that may not be readily...
A Unique Strategy To Give To Your Heirs And To Charity
By Martin L. Pierce, FTMQuarterly Contributor
A common estate planning dilemma is deciding whether to leave your assets to charity, to your heirs, or both. In many cases, there may not be enough assets to leave a substantial amount to both charity and heirs. Therefore, the individual must decide one or the other. However, with some creative planning, there is actually a way to include both in your legacy by combining the forces of two powerful estate planning tools.
A charitable remainder trust (CRT) provides several income and estate tax benefits. But some are hesitant to use a CRT because the assets involved ultimately pass to charity, thereby causing children and grandchildren to receive less.
Well, here is some good news: You can still give a substantial amount of your estate to your descendants while also giving money to charity by combining a CRT with an irrevocable life insurance trust (ILIT). Let’s take a closer look at this technique.
Create a CRT
A CRT allows you to provide for your family today and to give to your favorite charities later. Under a CRT, the donor reserves income for a term of years or for his life. He may reserve the income for the joint lives of himself and his spouse or another person, such as a child.
After the term or death(s), the principal of the trust and the accumulated income must be distributed to charity. One or more charities can be named in the trust instrument. Also, the donor can retain the right to change the charitable beneficiaries.
There are two basic varieties of charitable remainder trusts. First, a Charitable Remainder Annuity Trust reserves a fixed sum of income for the donor, for instance, 5% of the initial value placed in the trust, for the term of the trust. This amount of income would be distributed to the donor annually.
The second type, a Charitable Remainder Unitrust, reserves a fixed percentage of the value of the trust from time to time, with the amount of the reserved income changing each year as the value of the assets goes up or down.
You will receive an income tax deduction in the year you fund the CRT (based on IRS-published tables and calculated at the CRT’s inception) for the value of the charitable interest—referred to as the remainder interest. In other words, your tax deduction is based on the estimated amount that the charity will receive. This estimated amount is equal to the value of the property transferred to the CRT minus the present value of the income you will receive over your lifetime.
For example, let’s say you created a CRT in November 2011 at the age of 60. You transferred $500,000 to the trust and reserved the right to receive 5% of the trust value each year for your lifetime. Your charitable income tax deduction would equal $81,675. The deduction may be limited based on your adjusted gross income, but you can carry over any excess deduction for five years.
Another CRT benefit: The trust is exempt from income tax. Accordingly, if you have highly appreciated assets that would otherwise be subject to a large capital gain upon transfer or disposition, you may transfer them to the CRT. The trust can then sell the assets without you or the trust having to pay any tax on the gain at the time of the sale. This allows you to potentially increase your cash flow as a beneficiary of the CRT.
Distributions from the trust to the noncharitable beneficiaries are taxable to them. In other words, the income you receive from the trust each year is taxable, based on a unique tier system. Under these rules, the income received by the trust and paid to the beneficiary is taxed in the order and the extent received as:
1. ordinary income
2. capital gain
3. tax-exempt income
4. return of principle
For more on the tax characteristics of the income paid each year, contact me. I don’t want to get too bogged down in tax jargon here. Just understand that the income paid each year is taxable, but the income received by the trust grows tax-free.
Lastly, the CRT must annually distribute at least 5% of the trust’s principal to the beneficiary. The percentage can be higher (within limits), but the greater the amount you are to receive during your lifetime, the lower the charitable income-tax deduction. When you die, the CRT will be subject to federal estate tax, but your estate receives a charitable deduction for the value of the assets that pass to the charity or charities.
Add an ILIT to Create a Powerful Strategy
When creating a CRT, many people choose to also draft an Irrevocable Life Insurance Trust (“ILIT”). When using this trust type with a CRT, the insurance proceeds (death benefit) replace the value of the assets passing to the charity. The income tax savings generated by the CRT combined with the additional cash flow the CRT provides to the beneficiary can help pay (or even fully pay) the insurance premiums.
If you are buying a new insurance policy to fund the ILIT, the trust should apply for the policy and own it from its inception. If the ILIT is properly created and administered, the policy’s proceeds should not be subject to federal estate tax or state estate or inheritance tax. This law differs from the law for existing insurance policies that are transferred to an ILIT. If you transfer an existing policy to an ILIT, you must live for three years after the date of the transfer for the policy to escape federal estate tax.
You may structure your CRT to pay the annual distributions to you for your lifetime and then to your spouse for his or her lifetime if your spouse survives you. If you structure your CRT this way, you might also consider purchasing second-to-die life insurance on your and your spouse’s joint lives via the ILIT. Second-to-die policies provide a death benefit payable on the surviving spouse’s death. Thus, the proceeds would be payable at the same time that the CRT assets are distributed to charity.
Upon your death (or upon the death of your spouse in the above case), the insurance proceeds could either be distributed outright to your children or be held in trust for their or others’ benefit.
The Power of a Plan
As you can see, taking the time to properly structure your estate is well worth it, both in the tax consequences and in the amount that you can potentially leave as a legacy. Wouldn’t it be an accomplishment to leave an inheritance both to your heirs and to a charity in which you strongly believe and support? The power of combining a CRT and an ILIT is just one way you can accomplish this goal. Although this strategy is not for everyone, it may be worth a second look for you and your financial future.
(Copyright ©2012, all rights reserved. Provided by Martin L. Pierce, Attorney, 423.648.4303, MPierce@MartinPierceLaw.com. Martin is a Business and Tax attorney who is Certified as an Estate Planning Law Specialist in Tennessee and through the American Bar Association-approved national professional and testing organization. He is also licensed in Georgia.
DISCLAIMER: This article provides general coverage of its subject area. It is provided free, with the understanding that the author, publisher and publication do not intend this article to be viewed as rendering legal advice or service. If legal advice is sought or required, the services of a competent professional should be sought. The author and the publisher shall not be responsible for any damages resulting from any error, inaccuracy or omission contained in this publication.)