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Are Charitable Trusts Better Than Stretch IRAs

Last update on: Jun 22 2020
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Owners of large IRAs search for ways to maximize the after-tax amount of the IRAs that will benefit their loved ones. In the past we have demonstrated that unconventional strategies often increase the after-tax amount heirs receive.

Sometimes it makes sense for an IRA owner to empty the IRA early, pay the taxes, invest the after-tax amount, and let the heirs inherit the taxable account. When the owner qualifies to convert a traditional IRA to a Roth IRA, it often makes sense to pay the taxes to convert the IRA and leave the Roth IRA to the heirs.

An IRA owner who does not want to pay taxes today or wants to consider another option should take a look at leaving the IRA to a Charitable Remainder Trust instead of directly to beneficiaries. The heirs could end up with more security.

We have discussed CRTs in past visits. The property owner creates a trust and transfers property to it. The trust invests the property and pays annual income to beneficiaries named by the owner for either life or a term of years. After payments to the beneficiaries cease, the trust remainder goes to charities named by the owner.

With an IRA, the CRT would work like this. Either now or in the will, the IRA owner would establish a charitable remainder trust. The trust would be named beneficiary of the IRA. After the owner’s death, the trust takes a distribution of the entire IRA. Because the trust is charitable, it would not owe income taxes on the distribution. In addition, the estate would receive a deduction for the present value of the remainder interest the charity eventually would receive. The amount of this deduction would depend on prevailing interest rates and the ages of the beneficiaries. The deduction could be important if the estate is large enough to be taxable.

The trust invests the money. It does not pay taxes on income and gains earned on its investments. The trust makes annual distributions to the beneficiaries as designated in the trust agreement.

The trust most likely would state that the surviving spouse would receive income payments for life, and then the children would receive income for the rest of their lives. Then, the charity receives the balance.

The best results probably would be achieved from a unitrust, which would distribute a percentage of the trust’s value each year. If the trust increases in value, the distributions would increase. If the trust value declines, payments would decline. A standard CRT provision is to distribute 5% of the trust value annually. If the investments earn at least 6%, the fund and income grow over time.

After the beneficiaries pass away, the remainder of the trust goes to the charities designated in the trust agreement. If the trust grows over time, the charities receive more than the original IRA balance, though the beneficiaries received income for life.

An advantage of the CRT is that the trustee makes the investment decisions. If the IRA owner is concerned that the beneficiaries might not make wise investment choices, selecting a good money manager to be trustee or co-trustee can make the wealth longer. The unitrust feature means the income distributions will last longer than if the IRA were inherited by the beneficiaries. If the IRA were inherited, distributions would be made based on the life expectancies of the beneficiaries. If they exceeded their life expectancies the IRA balance and their income distributions would decline.

A possible disadvantage of using the CRT is the beneficiaries cannot take additional distributions if they need or want the money. The CRT would make only the designated annual distributions. The rest of the money belongs to the charities.

The assumptions one uses will indicate which strategy is better from a financial standpoint. In a recent article in Tax Notes Today, Professor Kevin J. Sigler demonstrated that with the CRT the income distributions would last longer and would increase slowly over time. The amount left for the charity also would increase. Those results depend on the investment return exceeding the payout ratio of the trust. Otherwise, the charities would receive less or the trust could run out of money.

Using a CRT as trust beneficiary is a way to ensure that income distributions continue no matter how long the beneficiaries live. It also is a way for an IRA owner to provide for both the beneficiaries and for charity.

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