What is Charitable Planning?
Charitable planning is one of our most favorite topics.
Your estate plan is your final statement about what you hold dear to your heart. If you care deeply about particular programs or issues, then those programs or issues should a part of your estate plan. And yet estate planners are often reluctant to explore with a client whether the client wishes to provide for organizations – many times because the estate planner either does not have charitable planning or because they fear family members will contest a gift to a charity over family.
During life, most gifts to charity are made from current income, most often by payroll deduction, check or credit card. When you make charitable gifts at death or give away an asset you own during life, the process is more complicated than simply writing a check. As a result, charitable gifts of this sort are usually called “planned gifts.”
A bequest is the simplest way to make a planned gift to an organization. “I leave $10,000 to the Smithsonian Institution in Washington, D.C.” Instead of a specific dollar amount, a bequest can identify a particular asset. “I give my 1939 Bugatti Type 57 to the Peterson Automotive Museum.” Unless the bequest specifies a purpose, the assets go to the charity for the organization’s general use. You can be very specific in designating a purpose. “I give $50,000 to the Orange County SPCA to help spay/neuter animals whose owners cannot otherwise afford to do so.”
Retirement plan assets can be especially useful in making planned gifts to charity because they lead to a triple tax whammy if you leave them to an individual:
- The tax-deferred growth in retirement plan accounts will be subject to income tax as funds are withdrawn from the account, although this tax hit is usually softened by withdrawing only the required minimum amounts every year.
- If your estate exceeds your federal estate tax exemption, your retirement assets will be subject to the 40% federal estate tax unless you leave these assets to your spouse using the unlimited marital deduction.
- If they are subject to the estate tax, chances are pretty good that your beneficiaries will need to withdraw money from the accounts to pay the estate tax bill, which means the typical approach to soften “tax whammy number one” will not work.
Leaving your retirement plan assets to charity avoids all three of these negative tax results. Since a charity is tax-exempt, it will not owe tax on funds transferred out of your retirement plans. There is an unlimited charitable deduction from the estate tax calculation, which means assets passing to charities avoid the estate tax calculation altogether.
Many people buy life insurance policies while they are young to ensure a few particular goals: paying off a mortgage, making sure their spouse can live comfortably, and providing funds for college educations for their children. As you mature, saving and financial planning often take care of these issues, making life insurance unnecessary. It is very easy to change the beneficiary of a life insurance policy to your favorite charity so the proceeds, if they are no longer needed for their original purposes, can instead support a program or organization you have come to value.
Split-interest planned gifts can be used to provide a charitable benefit while you are alive and can result in powerful tax savings. “Split interest” simply means that one person receives the current income from an asset while another person or charity eventually receives the asset itself. Here are two common split-interest charitable gifts:
- A charitable remainder trust (“CRT”) allows you (and your spouse) to retain the income of an assets for your lifetime(s) or a period of years while avoiding both the income tax on the sale of the asset and the estate tax that would be due if the asset remained in your estate. You (as the creator of the trust) transfer title to an asset to the trustee of the trust (a job you can also hold) and you reserve the right, for your lifetime or a number of years, to receive monthly, quarterly or annual payments based loosely on the income generated by the asset. When your income interest ends, usually at your death, the asset passes to a charity.
The transfer to the CRT results in an immediate income tax deduction based on the amount that will eventually pass to charity through the CRT. That eventual transfer to charity will qualify for the unlimited charitable deduction from the estate tax, so you should not pay estate tax on the asset even though have received income from it up until the time of your death. Just as importantly, a CRT is a tax-exempt trust that does not owe income tax on proceeds of assets it sells.
Here is an example of a CRT in action. Twenty years ago, Stephen bought an investment property for $100,000. He paid cash for it and he has never borrowed against the property. Today, it is worth $750,000. Stephen is tired of being a landlord and would rather have $750,000 invested in something much more passive but he knows that if he sells the property, he will owe tax on the $650,000 gain. Using a CRT, Stephen transfers the property, resulting in a current income tax deduction (usually equal to about 10% of the value of the property). The CRT sells the property without paying any tax on the gain and reinvests the full amount. Stephen reserves the right to the income of the trust for his lifetime. At his death, the principal passes to Stephen’s favorite charity, a local university, free of any estate tax.
Unlike the revocable trusts discussed elsewhere on this site, a CRT is an irrevocable trust. Once it is established, it cannot be undone, making the planning for this kind of gift very important.
- A charitable lead trust (“lead trust”) is essentially the mirror image of a CRT. If Stephen had used a lead trust, then the local university would receive the income stream for a period of years and at the end of that term the assets in the trust would be distributed to Stephen’s children.
This arrangement is substantially different in the following ways. Stephen would not receive a current income tax deduction for the transfer to the lead trust unless he agrees to pay the income tax on any earnings (including tax due on the sale of the property) during the term of the trust. However, if the trust is properly structured, he will receive an income tax deduction every year based loosely on the amount that passes to the university that year, which should offset most of the tax due for the year. This is where lead trusts get interesting. At the end of the term of years, the principal of the trust passes to Stephen’s children free of any estate tax. If the trust is well managed, then the amount that passes to children equals or exceeds the amount of the original gift.
While a CRT is most often motivated by income tax concerns (avoiding the gain on the sale of the property), a lead trust is most often motivated by a desire to transfer appreciating assets to children with minimal estate tax implications. The two techniques could not be more different but both are possible because Congress wants to encourage charitable giving.