Charitable giving often plays a role in the estate planning process. The reasons to include it may comprise one or more benefits. For example, you may want to take advantage of tax benefits or the possibility of creating a legacy. Sometimes income- and estate-tax consequences are at the top of the list, and sometimes they are not. Regardless of the motivation, you should be aware of how different charitable giving strategies might impact your overall plan.
In this section, we will explore a few of the more common charitable giving strategies. They include:
- Outright gifts of cash or appreciated securities
- Bequests in your will or trust
- Naming charitable beneficiaries on retirement assets or life insurance policies
- Donor-advised fund
- Charitable remainder trust
- Pooled income fund
- Charitable gift annuity
- Charitable lead trust
We encourage you to discuss these strategies and others with your tax and legal advisors to evaluate whether they are a good fit for your tax situation and your charitable giving goals.
Outright gifts of cash or appreciated securities >
Giving cash or securities that you’ve held more than 12 months and have appreciated in value is simple and provides the charity with immediate use of your gift. You may also receive an income-tax deduction. The deduction amount varies with each individual’s situation and may be reduced due to adjusted gross income (AGI) limitations. Charitable deductions that are currently disallowed because of AGI limits may be carried forward for a five-year period. Certain high-income individuals may also find that their overall itemized deductions are subject to a reduction or “haircut” (sometimes known as a “Pease” limitation).
If you are subject to estate taxes, your charitable gift also provides the benefit of reducing your potential taxable estate.
Bequests in your will or trust >
You can add a charitable bequest to your will or revocable living trust. This lets you retain control of the assets during your lifetime and benefit a charity upon your death. Bequests may be more appropriate than lifetime gifts if you are charitably inclined but have concerns regarding your retirement income needs. If you are subject to estate taxes, the bequest will reduce your taxable estate.
Naming charitable beneficiaries >
You can name a charity as a beneficiary of retirement assets, such as an IRA, 401(k), or other retirement assets, which may be subject to both estate and income taxes in large estates. (Remember, however, that for estates valued less than $5,490,000 in 2017, the federal estate tax is not a factor.)
When you leave retirement assets to a nonspouse (children or other individual), these beneficiaries must pay income tax on these assets. On the other hand, if you name a charitable beneficiary, it does not pay income taxes. In addition, if you are subject to estate taxes, this gift reduces your potential taxable estate.
You may also name a charity as the beneficiary of a life insurance policy to reduce your taxable estate.
Donor-advised fund >
Donor-advised funds provide another simple charitable giving opportunity. These funds are available through community foundations and charitable funds established by mutual fund companies.
Donor-advised funds allow individuals to make irrevocable contributions of cash or securities. The donor potentially receives an immediate charitable income tax deduction for each gift’s fair market value. (Multiple gifts may be made over the donor’s lifetime.) While the assets must eventually be used for charitable purposes, there is no mandatory distribution time for the fund, so the donor may take several years to deplete it.
The assets are removed from the taxable estate when they are added to the fund, reducing any potential estate tax liability. In addition to the tax benefits, the donor may name the account, giving him or her the ability to enhance their visibility in the philanthropic community.
Charitable remainder trust >
A charitable remainder trust, commonly referred to as a CRT, can benefit you and one or more of your favorite charities. This type of trust lets you convert an appreciated asset into lifetime income for you or another beneficiary without paying capital gain taxes when the asset is sold. A CRT can also provide you with a current tax deduction, and because you are removing assets from your estate, reduce your taxable estate. It also lets you make a future gift to the charity (or charities) of your choice.
Here’s how a CRT might work for you:
First, let’s say you donate $1 million in stock that appreciated in value while you owned it to a CRT. (A CRT can be funded with any amount you choose.)
Second, the stock is sold within the trust, free of capital gain tax. The proceeds are typically reinvested to create a diversified portfolio.
Third, your trust is designed with a 6% annual payout. On a $1 million trust, you would receive $60,000 per year. If your stock was paying less than that in dividends, you would have the opportunity to increase your cash flow. (A CRT can be designed to provide either a fixed or variable payout based on the annual value of the trust assets.)
Fourth, in addition to the income stream, you would also be eligible for a current income tax deduction. The amount would not be for the full $1 million because the charity has to wait for the duration of your lifetime (during which you would be withdrawing 6% a year from the trust) to receive the gift. Therefore, the value of the gift is less than the $1 million, and your charitable deduction is the “present value” of the amount the charity is expected to receive after you die.
Finally, when you die, assets remaining in the trust are distributed to the charities you specified. You may reserve the right to change or add charitable beneficiaries during your lifetime. Your estate planning attorney can provide this flexibility when drafting your document.
In addition to appreciated securities (such as stocks or bonds), you can donate cash and, with proper planning, real estate to a CRT. However, not all types of assets are appropriate. For example, special rules apply to gifts of tax-deferred assets, such as IRAs, retirement plan accounts, and annuities. Gifts of these types of assets while you are alive are not practical because gifting these assets triggers income tax to you.
However, it is possible to make a CRT the beneficiary of an IRA or retirement plan after your death. Your partner or spouse could receive a payment from the CRT for life, and the balance of the account would go to charity after the death of the partner or spouse. The present value of the income payments to an unmarried partner is included when computing the value of your taxable estate; if you are married, the gift of continuing income to your spouse is not a taxable gift because of the unlimited marital deduction. Other items, such as tangible personal property and mortgaged property, may not be ideal to put in a CRT because they each have their own complicated issues when donated to a CRT.
Under this scenario you could potentially receive more income than you were getting from ownership of the stock, a charitable income tax deduction, and a reduced taxable estate. You can also sell appreciated assets or diversify a large position you hold in a single stock with no immediate capital gain tax. But if the CRT was for your lifetime only, the remainder (what’s in the trust at your death) passes to charity and would not benefit your partner, spouse, or children.
Let’s see how you can retain the advantages of the CRT while still providing an inheritance for your partner, spouse, or children.
This can be accomplished by establishing a “wealth replacement” trust, that is, an irrevocable life insurance trust or ILIT.
In this hypothetical example, you’re receiving $60,000 in taxable income annually from the CRT. Let’s say you keep only $40,000 to pay taxes on the income and supplement your annual income. You use the additional $20,000 to make gifts that are used to acquire life insurance in an ILIT with a $1 million death benefit. Keep in mind, income from the CRT is taxable to you, so your gifting is funded with after-tax income from the trust. Also remember that life insurance premiums vary based on your age, and you must qualify through the underwriting process. The amount used here is only hypothetical.
Upon your death, the insurance benefits paid into the ILIT will be both income- and estate-tax free and can be distributed to your spouse, partner, and/or children according to the trust’s terms.
By combining a CRT with an ILIT, everyone may benefit. You get an income stream along with an upfront tax deduction. Your favorite charities receive a gift. And your beneficiaries can receive tax-free insurance proceeds instead of taxable assets from your estate.
Keep these alternatives in mind:
You can keep your appreciated securities until you die, to be included in your taxable estate. If you have a taxable estate, your beneficiaries will receive the balance after paying estate taxes.
You may decide to sell your appreciated securities now and pay any taxes. You have access to all of the principal as well as income. You pay capital gain taxes now, and your beneficiaries may owe estate taxes later.
Or you could give appreciated securities to charities now and take the full tax deduction. This alternative will provide you a larger tax deduction, but you will no longer own the asset or receive any income.
Talk with your attorney and tax advisor to discuss if a CRT is right for you.
Pooled income fund >
The pooled income fund shares some characteristics with a CRT, and individuals who like the concept of retained income but don’t want the complexity of a trust may find it attractive. It is a simple strategy available through some charities.
The pooled income fund provides the donor with an income stream during his or her lifetime. This is taxable to the donor as ordinary income. The income is not fixed; instead, it will vary based on the fund’s yield every year. Due to the variable income payout, this technique may not be appropriate for individuals who want a fixed income stream.
The charitable income tax deduction is based on the present value of the charity’s remainder interest. The deduction is calculated when the irrevocable gift is made to the fund. The charity receives the account balance upon the donor’s death.
Unlike with a CRT, the donor does not need to have their attorney draft a trust document. The pooled income fund offers administrative simplicity and the ability to generate some income. It also provides an individual the opportunity to diversify a large position in a single security without immediate tax consequences. And it creates a partial or pro-rated charitable income tax deduction and provides a charitable legacy. Potential estate taxes may also be reduced.
Charitable gift annuity >
A charitable gift annuity is an unsecured contract between a charity and a donor. The donor gifts assets to the charity in exchange for an income stream for the donor’s life. The payout is made by the charity; it is not guaranteed and does not involve an insurance company or commercial annuity. The charitable income tax deduction will be less than the full amount of the gift because the donor retains the right to the income stream. The donor’s deduction will be based on the charity’s remainder interest. The deduction is calculated at the time the assets are donated to the charity. The charity keeps the remaining balance at the end of the term.
You can structure a charitable gift annuity to provide income not only for your life but also for the life of a spouse, partner, or child. If the successor income beneficiary is not your spouse, this can have gift- or estate-tax implications, so be sure to work closely with your attorney and tax advisor to determine whether it is appropriate for your situation.
Charitable lead trust >
A charitable lead trust (CLT) strategy combines charitable giving and wealth transfer goals. This irrevocable trust may be funded during your lifetime or upon your death. During the trust term, which can be for the donor’s life or a set number of years, the trustee pays an income stream to one or more charities. At the end of the trust term, the principal is distributed to family members or a family trust. Because the gift to the individual beneficiaries is delayed, tax law allows donors to discount the value of the family gift. This gift also reduces potential estate taxes. Let’s take a look at an example.
Assume you contribute $1,000,000 to a CLT during your lifetime. The trust makes an annual payment of 5% to charity for 10 years. This payout may be fixed or variable depending on the type of CLT. A charitable lead annuity trust (CLAT) has a fixed payout; a charitable lead unitrust (CLUT) has a percentage payout that changes each year with the portfolio’s value.
The IRS discounts the $1,000,000 gift to your family to $603,0001. You must file a gift tax return, but no tax will be due; however, the gift will use $603,000 of your $5,490,000 gift tax exclusion. If the portfolio generates a total return of 5% or more over time, your partner, or family members could receive more than $1,000,000 after 10 years. If the portfolio does not generate 5% per year, the amount remaining will be less than your original gift.
This type of trust differs from the other strategies because it is not exempt from income taxes. Either the trust or the donor will pay the annual income tax liability, depending on how the trust document is drafted.
A CLT may appeal to you if you wish to benefit a charity now and your individual beneficiaries later and reduce potential estate taxes.
1 Assumes a CLUT and a Section 7520 rate of 2.0%.