For almost 25 years investors have experienced general appreciation in the value of their investments. However, the last few months may have left many of them wondering if that's about to change. What's more, those with considerable wealth also face the potential for higher income-tax, capital-gains-tax and estate-tax rates in the future, if the Democrats win the White House. All of that can certainly confuse the ifs, whens and hows of leaving legacies and supporting philanthropic causes.
But the low-interest rate environment we're in has opened up an opportunity for the benevolent wealthy to avoid an increase in estate taxes, or a decrease in the exemption amount: Charitable Lead Trusts (CLTs). Here is how high-net-worth clients can use these charitable trusts to pass more money to charities now, and cherished family members later — with much less going to Uncle Sam.
CLTs allow your clients to provide a level of income to one or more charitable organizations over a period of time. Any money left over can either revert to the donor, or (more commonly), to younger family members. The initial deposit amount, charitable recipients, term and eventual beneficiaries can all be determined by the donor.
If the income to the charity is a set dollar amount (like an annuity), the vehicle is a “CLAT” (charitable lead annuity trust). A less-common variant pays the charity a fixed percentage of the value of the CLT, and is known as a “CLUT” (charitable lead unitrust).
Here's where the tax benefits come in: The donor gets a gift-tax charitable deduction in the year the money is placed in the CLT. The size of the deduction is based on the present value of the income stream that's going to the charity. The portion of the donation that is not deductible may incur gift taxes. But it's possible to use the charitable deduction to offset the gift taxes, or to draw upon a portion of the client's $1,000,000 lifetime exemption. Once the pre-determined term of the charity's income stream expires, any money left in the trust can pass to the beneficiary of the client's choice — like her children — usually free from estate taxes.
Some Quick Math
Say your 50-year-old clients have $1,000,000 that they both want to, and are able to part with — as long as they can use the money to help a charity now and their adult children later.
The clients use the money to fund a charitable lead annuity trust, set up to pay out $50,000 per year to qualified charities for 20 years. At the end of the two decades, their adult children will get whatever is left over.
According to the handy calculators at www.giftlawcalc.com, the donor parents get a gift-tax charitable deduction of $667,640 for their $1,000,000 deposit. The present value of the kids' remainder interest is $332,360.
Assuming the assets in the trust earn a hypothetical return of 8 percent per year, and $50,000 of that goes to charity each year, in 20 years the adult children could have as much as $1.8 million to divvy up among themselves — free from gift or estate taxes.
The reason now is an ideal time to consider this strategy is that the present value of the annuity (and the value of the potential tax deduction) is determined by the IRS-applicable federal rate, published each month under Section 7520 (and available at www.irs.gov).
The lower the current rate, the higher the present value of the annuity (and hence the greater the tax deduction provided by the charitable portion of the gift). And as the charitable portion of the gift rises, the current (taxable) value of the remainder interest declines.
The example above used the rate as of February 2008 (4.2 percent). If the transfer had been made a few months earlier, when the rate was 5 percent, the value of the charitable gift would have been about $44,000 less. And the potentially taxable cost of the kids' interest would have been correspondingly higher.
The Good And The Bad
Some of the less tangible, but perhaps more valuable, benefits of this strategy include the notion that the parents may want their children to receive a good-sized inheritance — just not right now.
The CLT allows the parents to get the money (and any future net growth) out of their estate, but ensures the kids will only get their hands on the dough several years down the road. But just because the children won't get the remainder in the trust for several years, they can still work with the parents to decide which charities will receive the income stream from the CLT.
Of course there are drawbacks too. First, the “non-grantor” version of the CLT profiled above means the deposit is irrevocable, and the donors can't get the money back.
But don't despair — next month we'll cover how your clients can cut their taxes now and still get use of the money through “grantor” CLTs, as well as via the mirror-opposite of the CLT: the charitable remainder trust.
Another drawback: If the assets in the trust underperform the stated charitable distribution rate, principal may have to be tapped. Ergo, there may be less leftover for the eventual heirs.
Although it's theoretically possible to establish a CLT with any dollar amount, the tax and legal bills your client will incur make the move advisable only if the initial sum is at least in the middle six figures.
Despite the seemingly comprehensive information in this column, don't use it as your sole source of information for suggesting CLTs to certain clients. Bring in the client's CPA and estate-planning attorney as soon as the client expresses an interest.
In the meantime, there are a couple of places you can go for more background on this (and other) charitable giving strategies, such as GiftLaw (www.giftlaw.com) and the Planned Giving Design Center (www.pgdc.com).
Writer's BIO: Kevin McKinley CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. You can reach him at [email protected]