A couple wants to take income from highly appreciated assets, give some of those assets to charity, avoid capital gains tax on the transfer and reduce their taxable estate. Are they asking too much? If they use a charitable remainder annuity trust, then perhaps not. Further, if the CRAT allocates at least some of its assets to a deferred variable annuity paying a guaranteed minimum annuity income, then it can guarantee income for the couple and enable the couple’s charity to get a reasonable amount at their deaths.
Charitable Remainder Annuity Trust
A CRAT is an irrevocable trust with at least one non-charitable income beneficiary and at least one charitable remainder beneficiary. A donor transfers assets to the trust and receives an income during life or for a term of years (not exceeding 20).
Whatever remains at the donor’s death or at the end of the term goes to the charitable beneficiary. The transfer generates a charitable deduction for the donor, but only for the present value of the charity’s remainder interest. Only one transfer to a CRAT is allowed.
Highly appreciated assets work well as a transfer to a CRAT because the donor avoids capital gains tax on the transfer. CRAT income is set between 5% and 50% of the value of the original transfer and may not change. Income is further limited by a probability test designed to help ensure that something from the original transfer remains for the charity.
John and Mary Smith, age 65, are worth $5 million, $1 million of which is highly appreciated stock. They want an income from their portfolio, but also want to make a substantial donation to charity when they die. They additionally desire to remove the portfolio from their taxable estates and to avoid capital gains tax.
Their attorney drafts a CRAT into which John and Mary transfer their $1 million stock portfolio. The transfer avoids capital gains tax and removes the asset from their taxable estate. CRAT income is set at $50,000 (5% of the initial transfer) annually for their joint lives, an amount that will never change (assuming the trust’s investments perform well enough to sustain the income).
John and Mary’s CPA tests the 5% income requirement against the probability test and it passes. The CPA also tells them that their transfer produces a $393,490 charitable deduction, which is the present value of the charity’s anticipated remainder. To the extent the deduction does not exceed 50% of John and Mary’s adjusted gross income, they may use it in the present year. Otherwise, they may carry forward the unused part for up to 5 more years.1AE1511 1106
The CRAT trustee sells the $1 million portfolio and uses part of the proceeds to buy a deferred variable joint life annuity that immediately annuitizes into a lifetime stream of income. At John and Mary’s ages, the annuity pays a minimum lifetime income equal to 6% of the premium used to buy it, net of any fees. Income could be more if market conditions are positive. The annuity will produce half the CRAT income, but the trustee uses less than half the trust assets–$416,667–to buy it. The rest of the portfolio, $583,333, goes into a diversified portfolio of stocks and bonds. It need only generate a 4.3% annual return to produce the rest of the CRAT income.
If the CRAT assets and variable annuity experience no growth, the VA will still pay $25,000 per year. The rest of the CRAT portfolio may eventually deplete its assets through continuing withdrawals, but more slowly than if it comprised the entire portfolio and had to pay a greater share of income.
If sub-account performance is positive, VA income could grow, reducing the income requirements for the non-annuitized portfolio and allowing those assets potentially to grow for the benefit of the charity.
The variable annuity may also pay a death benefit, which is typically an amount equal to the premium paid for the annuity contract minus the cumulative income paid at the date of death. Combined with remaining assets in the CRAT, this feature enables the CRAT to provide a remainder for the charity at the Smiths’ deaths.
Annuity income comes to the CRAT trustee with an exclusion ratio. The trustee receives the annuity premium in equal, non-taxable annual installments over John and Mary’s life expectancy. Any additional annuity income received during the year is treated as ordinary income.
However, John and Mary’s income is not taxed according to the exclusion ratio. Rather, it follows the “ordering rules.” John and Mary’s income must account first for all ordinary income from both the annuity and other investments the CRAT owns. After that, any dividend income must be accounted for, followed by capital gains, non-taxable income and trust principal.
Including a deferred variable annuity with a minimum guaranteed annuity income to provide CRAT income helps this plan achieve its 4 objectives: (1) provide income for the donors; (2) remove a sizeable asset from the clients’ estate; (3) avoid capital gains tax; and (4) provide a benefit for a charity. Consider a variable annuity as part of a client’s charitable giving plans.