For Charitable Trusts, The Tax Icing On The Cake

A good estate planning idea may have become even better, thanks to the latest changes in the tax code. If you already were inclined to set up a charitable remainder trust (CRT) to protect assets from estate tax and support a favorite philanthropic cause, there now are several extra tax incentives to consider.

Three key income tax changes for top earners could add to the possible appeal of a CRT. The first two provisions were included in the American Taxpayer Relief Act of 2012 (ATRA), while the third was part of the Patient Protection and Affordable Care Act of 2010 (PPACA). The three changes are:

1. A higher top tax rate. Under ATRA, the top tax rate of 35% is raised to 39.6% for single tax filers with income above $400,000 and joint filers above $450,000. (The other income tax rates remain the same.)

2. Steeper rates for capital gains and qualified dividends. The usual maximum 15% tax rate for long-term capital gains and qualified dividends jumps to 20% for tax filers above those same income thresholds. Short-term capital gains are taxed at ordinary income rates—and those, again, now reach as high as 39.6%.

3. A new Medicare surtax. Beginning with your tax return for 2013, the PPACA may add a 3.8% Medicare surtax. It applies to the lesser of net investment income or the amount by which your modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers.

As a result of these changes, you might pay a combined 43.4% tax rate on a portion of your income—and that doesn’t include state income taxes. However, you might be able to reduce the impact of these higher taxes by using a CRT, which can let you get tax benefits now while providing protection for the future.

Creating a CRT begins with an irrevocable transfer of assets into the trust. Ideally, you should contribute an appreciated asset (for example, stock or real estate) that would generate a taxable capital gain if it were sold outside the CRT. Investment gains inside a CRT aren’t taxed. But keep in mind that the transfer is irrevocable—these assets aren’t coming back.

The trustee you appoint for the CRT—it could be an institution or an individual—manages the assets. Under terms of the trust, your beneficiaries—often your children—receive annual income. When the trust term ends (it can’t be longer than 20 years), or upon the death of the last beneficiary—whichever comes first—the remaining trust assets go to the charity you’ve selected. During your lifetime, you can change the designated charity and specify how it is to use the donation.

Example: You and your spouse own real estate you bought two decades ago for $200,000. You transfer the property, now worth $1 million, into a CRT. The trust sells the property, invests the proceeds, and pays you and your spouse 8% ($80,000) in annual income. Here is what you will have accomplished:

  • As long as the appreciated assets have been transferred to the CRT, a tax-exempt entity, before being sold, you won’t be taxed on capital gains, which also won’t be subject to the 3.8% surtax.
  • You can claim a current tax deduction for making a charitable donation. The amount of the deduction depends on the present value of the future gift, the ages of you and your spouse, prevailing interest rates, the type of charity, the amount of income you receive, the kind of gift, and the trust’s terms. (Some high-earners may not be able to deduct the entire value of the contribution.)
  • The family income tax bill is reduced. The income distributed from the CRT is taxed to your children, who may well be in a lower tax bracket than you are. And they probably won’t have to pay the 3.8% Medicare surtax.
  • There is no estate tax. If you had left your children the property instead, they might owe estate tax of up to 40% of the value (based on the top estate tax rate under ATRA).

Of course, even a bequest reduced by taxes would be more than your kids will receive from the CRT. To remedy that, you could use part of your current tax savings to purchase a $1 million “second-to-die” life insurance policy with an irrevocable life insurance trust naming your children as beneficiaries. The cost depends on how old you and your spouse are as well as other factors. When you and your spouse are both gone, your kids receive $1 million in tax-free proceeds and the charity receives the trust assets.

Of course, these are only the broad strokes of this tax planning technique. Obtain professional guidance to determine whether it’s right for you.

This article was written by a professional financial journalist for G.W. Sherwold and is not intended as legal or investment advice.

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