By Juan C. Ros, CFP®, AEP®, CEPA
Updated September 2021
Today’s interest rates are causing challenges for savers faced with punishing savings rates. But for others, ultra-low interest rates can be a potentially powerful ally when it comes to planning the transfer of an estate, especially an estate that is subject to estate tax.
First, a refresher. Under current federal law, an individual may transfer $11.7 million (2021) during lifetime or at death, free of gift or estate tax. Married couples may transfer $23.4 million. This estate tax exemption amount will sunset after 2025 and revert to $5 million per person, adjusted for inflation, beginning in 2026.
Estate planning professionals can and do propose complex tools and vehicles for avoiding or minimizing the estate tax. For those who are charitably inclined, there is one estate planning strategy that is not only relatively simple to establish but can also meet both philanthropic and estate-transfer goals — and is particularly powerful now due to the low-interest-rate environment. I am referring to the charitable lead trust.
How It Works
A donor (the “grantor”) contributes assets to the charitable lead trust. The trust makes distributions to charity for a set number of years. The charitable distributions are predetermined at the outset. After the term of years, the trust terminates. Whatever remains passes to the next generation.
Because the assets are eventually ending up in the hands of the donor’s heirs, there is a reportable taxable gift to the heirs when the trust is funded.
This is where the leverage provided by today’s low interest rates comes in.
Before the assets transfer to the next generation, there are charitable distributions that need to be made in between. At the time the trust is funded, the donor receives a charitable gift tax deduction for the present value of those charitable distributions. That gift tax deduction offsets the taxable gift to the heirs.
There is a specific interest rate known as the applicable federal rates (or AFR for short) that is used in calculating the size of the charitable gift tax deduction. The lower the AFR, the higher the gift tax deduction. And right now, the AFR is very low — a mere 1.0% for October 2021.
Keep in mind that for the month in which you establish and fund a charitable lead trust, you can use either the current month's AFR, or elect to use the AFR of either of the prior two months if the prior rate provides a higher tax deduction. Thus, the October AFR of 1.0% is available to donors who create and fund a charitable lead trust in December 2021, even if November and December rates inches higher.
In other words, a donor can pass on more assets to heirs now than at any other time in recent memory, thanks to a low AFR (and a corresponding high gift tax deduction).
An Example of the Power of the Charitable Lead Trust
Assume a donor and spouse have an estate worth $100 million. Absent any other planning, if they both pass away this year, they can transfer $23.4 million to heirs free of tax. The remaining estate will be subject to federal estate tax of approximately $30.6 million.
Now assume that same donor and spouse are charitably inclined. Their estate includes a diversified portfolio of stocks worth $80 million. They establish a charitable lead trust and decide to fund it with the $80 million portfolio. The trust will make annual payments to charity equal to 5% of the funding amount, $4 million, for a period of 16 years. The charities are selected by the couple, who reserve the right to change the charities each year. After 16 years, the balance of the trust will be divided among the couple’s children.
At the outset, the couple has made an $80 million taxable gift. However, thanks to the charitable distributions, the couple will receive a charitable gift tax deduction of $58,871,600 (using the October 2021 AFR of 1.0%), which reduces the taxable gift from $80 million down to $21,128,400.
Put a different way, they have just transferred $80 million of their estate to their children and used up only $21.1 million of their $23.4 million exemption amount – leverage of almost 4x the exemption! The balance of the estate (after the remaining exemption amount is used) will be subject to federal estate tax of approximately $8 million at today’s estate tax rates — saving over $22 million in federal estate tax from the first example.
What is more, if the portfolio earns an average of 6% per year while in trust, the heirs will divide a trust that has grown to $100.5 million after 16 years. The additional $20.5 million of growth is free of gift or estate tax.
And in the meantime, the couple has given away $60 million to charities.
Charitable lead trusts do have their drawbacks. In the example given, the children inherit the stock portfolio with the same basis as the parents and will eventually have to pay capital gains when they sell. This needs to be weighed against the significant estate tax savings. A charitable lead trust is also a taxable trust and needs to be carefully managed to avoid taxation inside the trust from the sale of assets. Finally, a careful analysis comparing a charitable lead trust to simply retaining the asset and paying the estate tax should be undertaken.
The time is now for estate planning with a charitable lead trust, particularly for clients who are philanthropic. This is a golden opportunity for both estate transfer and improving our world.
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