By Randy Fox
Retirement and estate planning have become increasingly complicated. Some affluent retirees find themselves forced to take required minimum distributions (RMDs) of their IRAs at 70 1/2 even if they don’t need the money—thus paying tax on income they don’t want. You can avoid paying taxes on this extra income by allocating it to charity.
I do a lot of work with the Planned Giving Design Center (PGDC), whose mission is to develop products and services for the charitable gift and estate planning industry that assist others in their efforts to increase philanthropy.
PGDC’s wide reach leads to many interesting opportunities, not the least of which are questions from donors about gift structures. Most recently we received a call from an inquisitive gentleman from the East Coast.
Here are the facts as the man explained them to me. He is 68 years old, still working, and quite healthy. He is divorced, has two grown children and a significant other. His total assets are around $5 million, but $2 million is in his IRA. His main concern is that when he turns 70 1/2, he will have to begin taking required minimum distributions from his IRA and he doesn’t think he’ll need the money to live on. Essentially, he would be paying tax on income that he didn’t need or want. Currently, he gifts regularly to the university he attended, but he has been doing that with appreciated securities.
This man told me that his advisor suggested the following plan: Withdraw the entire IRA and place the proceeds in a Charitable Lead Annuity Trust (CLAT). Despite not having all the information, I was able to determine that the CLAT was a grantor CLAT, which means the income tax deduction would flow through to the man’s personal return. According to the advice, the man would receive a 90 percent income tax deduction. My later calculations suggested that a 15-year, 7 percent payout trust would accomplish something close to that result. Gathering more information, I determined that this transaction would add about $140,000 to the man’s current year income taxes and raise his marginal rate from 28 percent to 39.6 percent.
Pros and cons of grantor CLATs
How does this transaction benefit our East Coast friend? Certainly, he does get to withdraw $2 million of IRA assets for only $140,000 of income tax. And he is able to make $140,000 of gifts per year for 15 years. He has gotten most of the toxic IRA asset out of his estate and has avoided a lot of income with respect to a decedent tax (IRD) for his heirs. Is there a downside? Several, actually. First, our East Coast friend loses access to his capital for 15 years. And even though he is healthy and working now, it’s impossible to know how long that will be the case. He may also have given away $2 million and, thus, disinherited his heirs from those funds. If the CLAT earns 7 percent or less, there will be little, if any, capital left. And while his income tax is “only” $140,000, he still has accelerated the payment of that tax into the current year.
What else could he do instead? Again, several things come to mind. First, he could do a charitable IRA rollover and make an annual gift that way. Beginning at the age of 70 ½, individuals can make up to $100,000 in charitable gifts each year from an IRA. These donations count toward your minimum distributions and are not included in your taxable income. However, since these donations aren’t included in your gross income, you also cannot claim tax deductions for these charitable gifts.
Second, he could name a charitable remainder trust (CRT) as the beneficiary of his IRA and allow that income stream to benefit his children and significant other. A CRT is a trust with a designated current beneficiary and a remainder beneficiary, such as a charity or foundation. While this would delay the gift to charity, there is nothing to stop him from making annual gifts to charity from his RMDs. He could also name his alma mater as the beneficiary of the IRA and purchase life insurance to replace the asset for his heirs.
This piece is based on an article that was originally published at CEG.
Randy Fox is a co-founder of EzCharitable, LLC, an online charitable training and consulting platform for professional advisors. Fox also serves as editor-in-chief of The Planned Giving Design Center.