Case Study: Should I do this?

Case Study: Should I do this?

Case study posted in Charitable Lead Trust on 27 October 2014| 3 comments
audience: National Publication, Two Hawks Consulting, LLC | last updated: 28 October 2014
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by Randy Fox

The wide reach of The Planned Giving Design Center (PGDC) leads to many interesting opportunities, not the least of which are questions from donors about gift structures, strange opportunities or other inquiries. Most recently Lee received a call from an inquisitive gentleman from the East Coast which he promptly turned over to me. It was a “should I do this?” call. Essentially, a proposal was on the table and he was confused by it.

Here are the facts as he explained them to me. He is sixty-eight years old, still working and quite healthy. He is divorced, has two grown children and a significant other. His total assets are around $5 million, but $2 million is in his IRA account. His main concern is that when he turns age 70½   he will have to begin required minimum distributions (RMDs) from his IRA and he doesn’t need the money to live on. Essentially, he will be paying tax on income that he doesn’t want. Currently, he gifts regularly to his University but he’s been doing that with appreciated securities.

An advisor (I’m not sure if it was a planned giving officer, an attorney or financial advisor) suggested the following: withdraw his entire IRA account and place the proceeds into a Charitable Lead Annuity Trust (CLAT). Without all of the information, I was able to determine that the CLAT was a Grantor CLAT, that is, the income tax deduction would flow through to his personal return. According to the advice he would receive a 90% income tax deduction. My later calculations suggest that a 15 year, 7% payout trust would accomplish something close to that result. Gathering some more information, I determined that this transaction would add about $140,000 to his current year income taxes and raise his marginal rate from 28% to 39.6%.

How does this transaction benefit our East Coast friend? Certainly, he does withdraw $2 million of IRA assets for only $140,000 of income tax. And he is able to make $140,000 per year of gifts for 15 years. He has gotten most of the toxic IRA asset out of his estate and has avoided a lot of income in respect of a decedent tax (IRD) for his heirs.

Is there a downside? Several, actually. First, he loses access to his capital for 15 years and though he is healthy and working now, it’s impossible to know how long that will continue. He may also have given away $2 million and, thus, disinherited his heirs from those funds. If the CLAT earns 7% or less, there will be little, if any capital left. And while, his income tax is “only” $140,000, he still has accelerated the payment of that tax into the current year.

What else could he do that could be considered? Again, several things come to mind. First, he could wait to see if the Charitable IRA Rollover is re-enacted and make an annual gift that way. Second, he could name a Charitable Remainder Trust as the beneficiary of his IRA and allow that income stream to benefit his children and significant other. While this would delay the gift to charity, there is nothing to stop him from making annual gifts to charity from his RMDs. He could also name his University as the beneficiary of the IRA and purchase life insurance to replace the asset for his heirs instead.

Want to know my answer to “should I do this?” Tell me what you think. Yes or No? Or do you have another recommedation? Leave a comment below.

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Re: Case Study: Should I do this?

I couldn't agree with you more. Planning with the full knowledge of the client's goals as well as his assets and cash flow needs is the only way to answer his questions.

Re: Case Study: Should I do this?

I couldn't agree with you more. Planning with the full knowledge of the client's goals as well as his assets and cash flow needs is the only way to answer his questions.

Re: Case Study: Should I do this?

Very interesting scenario, but it seems that many more facts would be needed before any kind of informed decision could be made. Nonetheless I made a stab at it using some simplified facts and assumptions below.

Going the CLAT route, if he has $2M IRA income and a $1.8M charitable deduction, it seems highly likely that he would have some carryover charitable deduction that would offset the $140K first year tax cost. And he would have to pay tax each year on the CLAT's income. Assuming a 7% return in the CLAT, all gains realized and some mix of capital and ordinary income for an average tax rate of 25%, that would be $35K annual income tax cost. Ignoring the charitable carryover issue, that makes a gross total tax cost of $665K, which in future dollars (i.e., after 15 years), would be about $900K. After 15 years he'd get $2M back from the CLAT, so net after tax would be $1.1M.

If instead he transfers $140K annually from IRA to charity, and we assume charitable IRA rollover enacted or no AGI limitations on charitable deduction, he ends up after 15 years with $2M IRA worth maybe $1.4M after tax. This makes the CLAT option less attractive in comparison.

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