Tuesday, August 18, 2015

Retirement and Charitable Remainder Trusts

I got a call from a potential client yesterday. Looking towards retirement he said "tax optimization" is his goal and he seems to believe that setting up a charitable remainder trust (CRT) is the way to achieve that. Unfortunately, he caught me off guard with some terminology from some online stuff he had been reading so I probably won't be gaining him as a client.

Also unfortunately, for him, based on his readings on the Internet he strongly believes that the distributions a donor receives from a charitable remainder trust are tax free. There are exceptions but having them apply is rare. In general, distributions from a CRT are taxable to the recipient. Technically, the nature of the income earned by the trust determines the taxability of the distribution. First, all the ordinary income (taxable at ordinary rates) is deemed to comprise the distribution, then any capital gains and finally any tax exempt income.

Example 1: Suppose a CRT starts with $100,000 of assets and earns a total of $9,000 during the year composed of $4,000 of ordinary income, $3,000 of long term capital gains and $2,000 of tax exempt interest. Let's assume the distributions are $5,000 per year. The ordinary income is deemed to be distributed first, then the long term capital gains, then the exempt interest. So our donor/taxpayer has $4,000 of ordinary income, $1,000 of long term capital gains and $0 of tax exempt interest.

Example 2: The CRT starts with $100,000 of assets and somehow manages to earn $5,000 of tax exempt interest. Now the $5,000 distribution is tax exempt to the recipient.

A problem is, in today's economy, it's somewhere between difficult and impossible to earn 5% or more on an investment in state and local bonds (the securities that generate tax exempt interest income) without taking extraordinary risks. On top of that, the trustee will be attempting to maximize the remainder interest (for the benefit of the charity) which is not conducive to investments in low interest bonds. Remember, the CRT isn't paying income taxes so the trustee has zero incentive to make investments that generate tax exempt income.

I regret not making a better impression on my caller for two reasons. First, I'm almost certainly not getting him as a client. Second, he's liable to make an irreversible decision based on his misinformation, something that would be avoided if he had me as his CPA.

Takeaway for me: Be ready for anything, particularly jargon created for use in sales pitches.

Takeaway for you: Don't believe everything you read on the Internet, especially about finances and taxes.

Caveat: The rules regarding charitable remainder trusts are way more complex and arcane than covered in this post. Don't even think about creating one for your favorite charitable organization until you've consulted with a tax professional, ONE WHO DOESN"T CARE WHETHER YOU CREATE A CRT OR NOT.

If you have questions about charitable remainder trusts or retirement planning or anything else related to income taxes, email me at bill@hollandbrowncpa.com. I promise I know more about this stuff than yesterday's caller probably believes.