CHARITABLE REMAINDER TRUSTS: THEY RE BACK BUT ARE THEY WORTH IT? Robert W. Dietz, CFA Associate Director Bernstein Private Wealth Management

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1 CHARITABLE REMAINDER TRUSTS: THEY RE BACK BUT ARE THEY WORTH IT? Robert W. Dietz, CFA Associate Director Bernstein Private Wealth Management September 2015 Bernstein does not provide tax, legal, or accounting advice. In considering the information contained in this outline, you should independently verify all conclusions before implementing any strategy on your own behalf or on behalf of your client. Parts of this outline are based on research originally published by Paul S. Lee, JD, LLM, and Stephen S. Schilling, CFA, of Bernstein Private Wealth Management, in CRTs Are Back (in Four Delicious Flavors) (October 2014, Trusts & Estates, pages 31 45).

2 I. Charitable Remainder Trust Basics The charitable remainder trust (CRT) is a split-interest trust that must pay a defined amount each year to a noncharitable beneficiary or beneficiaries for a defined period, after which the remaining trust property is transferred to one or more charitable beneficiaries. 1 In many cases, CRTs can enhance a donor s charitable capacity over time by allowing the donor to retain some economic benefits that reduce the cost of being philanthropic. Those benefits include the receipt of a partial income or an estate tax deduction, diversification of highly appreciated assets in a tax-deferred environment, and the retention of an annual stream of payments from the trust. a. The Structure: The donor makes an irrevocable contribution to fund the CRT in exchange for annual payouts either for a term of years, with a maximum of 20 years, or for the lives of one or more individuals. Donors can choose the payout structure they prefer. In a charitable remainder annuity trust, or CRAT, the payouts are in the form of a fixed annuity; in a charitable remainder unitrust, or CRUT, the payouts are a set percentage of the value of the trust principal. The annual payouts can be made to the donor or another designated recipient. Any remainder left in the trust at the end of the term or the donor s life passes to the donor s chosen charity or charities. b. Types of Charitable Remainder Trusts i. Annuity Trust (CRAT): Distributes a fixed dollar amount between 5% and 50% of the initial fair market value of the trust. ii. Unitrust (CRUT): 1. Standard: Distributes a fixed percentage between 5% and 50% of the net fair market value determined annually. 2. Net Income (NICRUT): Distributes the lesser of the unitrust amount or the trust s net income. 3. Net Income with Makeup (NIMCRUT): Distributes the lesser of the unitrust amount or trust income, while allowing for deficiencies between net income and the unitrust amount to be made up in future years, when net income exceeds the unitrust amount. 4. Flip NICRUT or NIMCRUT: The trust switches from a NICRUT or NIMCRUT to a standard CRUT after a triggering event occurs. a. A triggering event can be a specific date or a single event that is not under the control of the trustee or any other person. 2 1 IRC 664 1

3 c. Tax Benefits for Donors: The tax benefits for donors come in two forms: tax deferral and tax avoidance. i. The tax-deferral benefits to the donor are that: 1. The CRT itself is tax-exempt, so a highly appreciated asset can be contributed to the trust, diversified within it, and fully reinvested without tax. 2. Investments inside the CRT grow faster than they would in a taxable account since there is no tax drag on realized gains or taxable income. The donor will pay taxes gradually over time because the payouts are taxable based on what s been realized inside of the CRT, but the deferral of the tax hit allows for more assets to work longer. ii. The tax-avoidance benefits to the donor are that: 1. The donor receives an up-front income tax deduction based on what s expected to be left over for charity. 2. The CRT may also allow a donor to be able to spread income over multiple years, allowing for the income to be taxed at lower income tax rates by capturing multiple bracket runs, as described in section III of this outline. d. Maximum Allowable Lifetime Payouts i. The annuity or unitrust amount must be at least 5% and no more than 50% of the initial market value of trust assets. The actuarial value of the charitable remainder interest must be at least 10% of the property placed in the trust, 3 and charitable remainder annuity trusts (CRATs) must satisfy exhaustion rules. 4 ii. Today s extremely low interest rate environment, as reflected in the current IRC Section 7520 rate of 2.2% for August of 2015, 5 means that lifetime charitable remainder annuity trusts (CRATs) are available only to donors who are over the age of 70. On the other hand, charitable remainder unitrusts (CRUTs) are available even for donors who are as young as age Reg (a)(1)(i)(c) 3 IRC 664(d)(1)(D), 664(d)(2)(D) 4 See CRTs Are Back (in Four Delicious Flavors), Lee and Schilling, Trusts & Estates, October 2014, pages If an income, estate, or gift tax charitable contribution is allowable for any part of the property transferred, the taxpayer may elect to use the IRC Section 7520 rate for either of the two months preceding the month of the valuation date. See IRC 7520(a). 2

4 iii. The maximum allowable lifetime payout rates for CRATs are very sensitive to the IRC Section 7520 rate. In contrast, the IRC Section 7520 rate has a very limited impact on the maximum allowable lifetime payout rates for CRUTs. The tables below display the maximum annual allowable lifetime payouts for CRUTs and CRATs at various ages under a 2.2% and 6.0% IRC Section 7520 rate. *Assumes annual payout e. Taxation of Payouts to Noncharitable Beneficiaries i. Although CRTs are tax-exempt, distributions to noncharitable beneficiaries are not. The distributions are taxed pursuant to the category and class tier rules of accounting. 6 As shown in the display below, under these rules all income is first divided into three categories of income: ordinary, capital gains, and other. Within each category the income is further subdivided into different classes based on the federal income tax rate applicable to the income. As a general rule, the highest tax-rate income in each category and class is deemed to be paid out first but not always. 6 IRC 664(b) and Treasury Regulations Section (d)(1) 3

5 ii. The income is taxed when and if it is received by the noncharitable beneficiary, but the calculation of any taxes payable is determined at the beneficiary level. The tier rules essentially allow donors to defer what might have been a large tax liability in one taxable year and spread it over the term of the CRT as distributions are made. II. Charitable Remainder Trusts Prior to 2013 For the most part, prior to 2013, CRTs were relatively unattractive as a result of the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003, which significantly cut tax rates by accelerating provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the Bush tax cuts. a. Under JGTRRA, the top ordinary income tax rate and long-term capital gains tax rate were cut to 35% and 15%, respectively, from 38.6% and 20% prior to In addition, JGTRRA introduced qualified dividends that effectively allowed the dividends from most US corporations to be taxed at long-term capital gains tax rates instead of at higher ordinary income tax rates. The entire act was to sunset after 2010, which meant that absent legislative action, the tax rates were to revert back to their pre-2001 levels. The reduction in income tax rates, and the fact that this reduction was set to automatically increase after 2010, detracted significantly from the noncharitable benefits of CRTs. The up-front income tax deduction and the ongoing tax deferral provided by the CRT were worth less than in years past, when tax rates were higher. An even larger detractor was the very real potential that the CRT could effectively defer income into higher tax rates following the sunset after

6 b. Under these tax rate assumptions, we forecast in the median case that an 8% lifetime term CRUT, funded with zero-basis marketable securities, would have only had about an 18% chance of creating more personal wealth for a donor than an outright taxable sale of the appreciated securities, over 25 years. 7 III. Charitable Remainder Trusts Today Income tax rates for individuals have increased significantly with the enactment of the American Taxpayer Relief Act of 2012 (ATRA) and the imposition of the 3.8% net investment income tax (NIIT). 8 Today, the top federal tax rates on ordinary income and long-term capital gains including the NIIT are 43.4% and 23.8%, respectively, an increase of around 24% for the ordinary income tax rate and 59% for the capital gain and qualified dividend tax rates. In addition, federal tax rates are more progressive than they ve been in recent years. For joint filers in 2015, the highest income tax rates come into effect when taxable income exceeds $464,850, and the NIIT is applied when modified adjusted gross income exceeds $250,000. For a top taxpayer in Minnesota, the increase in taxes has been even worse, with the top Minnesota income tax rate now at 9.85%, which is an increase of over 25% from the top rate back in 2012 of 7.85%. 7 For more details on Bernstein s wealth forecasting model, see Wealth Forecasting Model (section IV below) and Notes on Wealth Forecasting System in the Appendix of this outline. 8 IRC 1411, part of the Health Care and Education Reconciliation Act of

7 As a result of these increases in both state and federal income taxes, there are significant tax savings that may be captured if taxpayers can take advantage of running the brackets by having income taxed at the lower rates. a. As shown in Display 1, for a federal taxpayer with a long-term capital gain of $1 million, the benefit of a full bracket run is estimated to be around $43,978. As shown in Display 2, for a Minnesota resident, the benefit from a full bracket run is even higher, at $49,990. A properly structured CRT can help donors capture this bracket-run benefit by enabling the donor to spread the income from a taxable event, such as the sale of appreciated assets, in one year over multiple years. b. Under these tax-rate assumptions, we forecast that in the median case an 8% lifetime term CRUT funded with zero-basis marketable securities would have about a 95% chance of creating more personal wealth for a donor than an outright taxable sale of the appreciated securities, over 25 years. 9 Display 1 9 For more details on Bernstein s wealth forecasting model, see Wealth Forecasting Model (section IV below) and Notes on Wealth Forecasting System in the Appendix of this outline. 6

8 Display 2 IV. Wealth Forecasting Model In the case studies that follow, we use our proprietary analytical model 10 to forecast a range of capital-market environments to examine the trade-offs between several variables relating to the funding of CRTs. Our analytical model marries the benefits of stochastic modeling with our structural model of the capital markets. In each instance we simulated 10,000 market scenarios or forecasts for the next 40 years, based initially upon the current state of the capital markets. With 10,000 different outcomes, the analytical outputs are probabilistic, and for the purposes of this outline, we are generally displaying the median outcomes, adjusted for inflation. In other words, instead of saying, for example, that the remainder value will be $10 million, the answer would be that there is a 50% chance of the remainder being at least $10 million or more in today s purchasing power. 10 Bernstein s analytical model is described in more detail in Notes on Wealth Forecasting System in the Appendix of this outline. 7

9 V. Publicly Traded Stock Case Study a. When a donor contributes highly appreciated stock to a CRT, whether the donor will be able to receive an income tax deduction based on the fair market value of the stock, rather than the cost basis, depends on the type of charitable organization that is able to receive the remainder interest. If the organization is a publicly supported charity, the income tax deduction will be calculated against the fair market value of the stock. If the organization is not a public charity, such as a private foundation, then the tax deduction will be based on the cost basis of the stock, 11 unless the stock is qualified appreciated stock under IRC Section 170(e)(5). i. To qualify for the exception under IRC Section 170(e)(5), the stock must be traded on an established securities market, and quotations must be readily available for the stock. In addition, the exception is available only if aggregate contributions made by the donor and the donor s family members are 10% or less of the outstanding stock of the corporation. There is no time limit on this 10% restriction. 12 b. Assumptions and Facts: In the following case study, we compare the contribution and sale of zero-basis single stock, worth $10 million, in a joint lifetime CRUT by a 65-year-old Minnesota couple to an outright taxable sale. The couple is interested in diversifying out of the concentrated single-stock position in favor of a globally diversified stock allocation. 13 i. The couple has a range of payout options to choose from. Based on their ages and today s 2.2% IRC Section 7520 rate, the maximum annual unitrust percentage they can choose is %. This maximum payout results in the charitable interest being valued at 10% of the funding value. 14 In this case, the charitable income tax deduction would be $1 million. ii. The minimum payout of 5% would entitle them to a much larger charitable income tax deduction of over $3.4 million. c. Display 3 shows how the range of CRT payout options is likely to impact the couple s personal wealth relative to a full outright taxable sale, based upon our projections for the capital markets. 11 IRC 170(b)(1)(B)(ii) 12 IRC 170(e)(5)(C) 13 The allocation to stocks is 21% US diversified, 21% US value, 21% US growth, 7% US small- and mid-cap, 22.5% developed international, and 7.5% emerging market. 14 IRC 664(d)(2)(D) 8

10 i. With the exception of the 5% payout option, using a CRUT to diversify their concentration in low-basis single stock will increase their personal wealth over 25 years in the median case. ii. In the case where the couple chooses the maximum unitrust percentage of %, we forecast in the median case that over 25 years the CRUT will create an additional $1.5 million of personal wealth relative to an outright taxable sale. iii. In the 8% unitrust scenario, we forecast in the median case a benefit of $1.1 million to personal wealth relative to the outright taxable sale. Display 3 9

11 d. In Display 4, where we include charity s interest, it becomes clear that the CRUT can truly be a win-win solution for many donors. With the maximum unitrust percentage of %, the remainder benefit to charity in year 25 is projected to be $1.6 million. This brings the total wealth created by the CRUT up to $16.7 million relative to the $13.6 million produced by the outright taxable sale in the median case. i. When viewed from a total wealth perspective, accounting for both the benefit/cost to personal wealth and charity s interest, the minimum unitrust percentage of 5% results in approximately 28% more wealth than the maximum unitrust percentage of %. ii. This display provides a very easy way for donors to decide where they want to be on the payout continuum. If charity is less important, then they ll favor a higher unitrust percentage, and if charity is more important, then they ll gravitate to a lower unitrust percentage. Display 4 10

12 e. The personal benefits from a CRUT build over time. Early in the term of a CRUT, the donor will have less personal wealth than had the donor just engaged in an outright taxable sale of the appreciated stock. Over time, the gap in personal wealth between an outright taxable sale and a CRUT will shrink until, with enough time, the CRUT results in more personal wealth. We call that moment in time crossover, and the speed at which crossover is reached is a function of the unitrust percentage selected. i. As shown in Display 5, based on our projections in the median case, we expected crossover to be reached after 18 years for the maximum unitrust percentage of %, 21 years for the 8% unitrust, and 26 years for the 5% unitrust. Display 5 11

13 f. As shown in Display 6, over very long time horizons (such as 40 years) the lower unitrust percentages actually create more personal wealth than the maximum unitrust percentage. In this case study, 40 years is likely beyond the 65-year-old couple s life span. However, for a very young donor who may only qualify for a 5% CRUT, a 40-year time horizon may be a very real possibility. Display 6 g. A key assumption in our case study is that the donor is using zero-cost-basis publicly traded stock to fund the CRUT. The personal wealth benefits of a CRT quickly diminish as the portion of cost basis to fair market value increases. i. In Display 7 we quantify, for different levels of appreciated stock, the likelihood that after 25 years, an 8% CRUT will create more personal wealth than an outright taxable sale. 12

14 ii. As shown in the display, the odds of an 8% CRUT creating more personal wealth relative to a taxable sale drop to only 53% by our projections, once the stock being contributed has a cost basis equal to 20% of its market value. iii. There is almost no chance for an 8% CRUT to enhance personal wealth over 25 years when funded with stocks that have built-in gains equal to 50% or less of their market value. This means that careful consideration needs to go into the selection of assets used to fund a CRT. Display 7 VI. Artwork/Collectibles Case Study a. The contribution of highly appreciated artwork to a CRT will not create a significant income tax deduction, but given the higher tax rate on realized gains from collectibles versus long-term capital gains, the tax deferral will be more valuable. 13

15 i. The income tax deduction for artwork contributed to a CRT is limited to the cost basis, unless the contribution is for the related use of a publicly supported charity. 15 The contribution to a CRT would not qualify for the related use exception, even if the remainder beneficiary is a publicly supported charity that otherwise would. In addition, the donor can t actually use the deduction until the noncharitable term ends, or the artwork is actually sold within the CRT. 16 ii. Artwork is considered to be a collectible; therefore, it is taxed at a federal rate of 28% for investors and collectors 17 instead of at the lower 20% longterm capital gains tax rate. For a Minnesota resident, the effective top tax rate is nearly 41.3% on collectibles, compared to 33.3% for capital gains. For the artwork creator and for dealers, the artwork is taxed as ordinary income. For a donor that is classified as an investor, the category and class tier rules are shown in Display 8. Display 8 15 IRC 170(e)(1)(B)(i) and Reg A-4(a) 16 See CRTs Are Back (in Four Delicious Flavors), Lee and Schilling, Trusts & Estates, October 2014, pages IRC 1(h)(4) 14

16 b. Additional considerations need to be given to the following planning issues when contributing art: i. Donors need to get a qualified appraisal and satisfy the charitable contribution substantiation requirements. In addition, the donor may also need to contribute additional liquid assets, so that the CRT can pay for expenses related to maintaining and insuring the artwork. ii. To avoid self-dealing and to ensure that the contribution to the CRT was a completed gift, the donor even if the trustee must not continue to retain the enjoyment of the artwork, such as displaying the work in his or her home or office. 18 c. Since the artwork is not likely to produce the liquidity necessary to make the annual distributions required by a standard CRUT, it may be necessary to structure the CRT as a flip net income with makeup CRUT (flip NIMCRUT). i. The flip event could be the sale of the artwork. The conversion to a unitrust distribution occurs in the year following the taxable year of the triggering event. 19 ii. Any undistributed amounts in the makeup account are forfeited at the time of conversion. However, there is the opportunity for donors to recapture the previously unpaid distributions accumulated in the makeup account by having any post-contribution appreciation allocated to income instead of principal. This can be accomplished as long as state law and the governing instrument allow for it. 20 From the donor s standpoint, a lower valuation or discounted valuation at the time of contribution is desirable. This is because the income tax deduction is already limited to cost basis, and postcontribution gain can be allocated to income. d. Assumptions and Facts: In the following case study, we compare the contribution and sale of artwork in a flip NIMCRUT by a 65-year-old Minnesota couple to an outright taxable sale. We assume the couple originally acquired the artwork for $100,000 and that its fair market value today is $10 million. Further, we assume the artwork is sold for $11 million net of closing costs one year from today and proceeds 18 See CRTs Are Back (in Four Delicious Flavors), Lee and Schilling, Trusts & Estates, October 2014, pages If a legally binding agreement for the sale exists at the time of the contribution, the donor may be required to recognize all income when the property is sold. 20 Reg (a)(1)(i)(b)(3) and IRC 643(b) 15

17 are reinvested in a globally diversified stock allocation. 21 We make the following assumptions with regard to the CRUT: i. The trust is structured as a joint lifetime term net income with makeup CRUT (NIMCRUT) that flips to a standard unitrust payout upon the sale of the artwork. ii. $1 million of post-contribution appreciation is deemed to be income for the purposes of determining the makeup distribution. iii. The charitable deduction is limited to the $100,000 cost basis. With regard to the standard unitrust distribution percentage, the couple has a range of payout options to choose from. Based on their ages and today s IRC Section 7520 rate of 2.2%, the maximum unitrust percentage they can choose is %. This maximum payout results in charity s interest being valued at 10% of the funding value. 22 Because their charitable income tax deduction is limited to their $100,000 cost basis, their charitable income tax deduction will only be about $10,000, assuming the maximum payout. The income tax deduction here is much less than the $1 million deduction used in the publicly traded stock case study. At $34,000, the income tax deduction for the minimum payout of 5% is still a tiny fraction of the $3.4 million income tax deduction used in the publicly traded stock case study. e. Display 9 shows, based on our projections for the capital markets, how the range of CRT payout options is likely to impact the couple s personal wealth in the median case after 25 years, relative to an outright taxable sale of the artwork. i. With the exception of the 5% payout option, contributing the artwork to a CRUT will increase their personal wealth over 25 years. ii. In the case where the couple chooses the maximum unitrust percentage of %, we forecast that the CRUT will create an additional $2.0 million of personal wealth relative to an outright taxable sale of the artwork. iii. In the 8% unitrust case, we forecast a smaller benefit of $1.1 million to personal wealth relative to the outright taxable sale of the artwork. 21 The allocation to stocks is 21% US diversified, 21% US value, 21% US growth, 7% US small- and mid-cap, 22.5% developed international, and 7.5% emerging market. 22 IRC 664(d)(2)(D) 16

18 iv. As compared to the publicly traded stock case study, we see a higher degree of benefit to personal wealth with the % payout, despite the dramatic reduction in the charitable income tax deduction. This enhancement is largely due to a more favorable balance between the value of the income tax deduction and the value of the tax deferral, as detailed below. v. For charity s interest, the remainder benefit in year 25, under the % unitrust, is projected to be $1.6 million. This brings the total wealth created up to $15.3 million relative to the $11.7 million produced by the outright taxable sale of the artwork. vi. From a total wealth perspective, the minimum unitrust percentage of 5% results in approximately 24% more in total wealth than the maximum unitrust percentage of %. Display 9 17

19 f. As shown in Display 10, assuming the maximum payout percentage of %, the crossover point for the donor that funded the CRUT with artwork is reached after just 16 years, which is two years sooner than the donor funding with stock. The story is different for the 5% unitrust, which takes the donor funding with artwork three years longer than the donor funding with stock to reach crossover. These results are due to the balance between the value of the income tax deduction and the value of the tax deferral. i. For the % unitrust, the tax deferral of the higher 41.3% collectibles tax rate (state and federal) more than overcomes the near total loss of the $1 million income tax deduction. ii. With the 8% unitrust, we see a near perfect balance between the near total loss of the income tax deduction and the higher tax-deferral benefits, with both donors reaching crossover after 21 years. iii. However, with the 5% unitrust, the near total loss of the $3.4 million income tax deduction is not easily overcome by the additional tax-deferral benefits of the higher collectibles tax. Display 10 18

20 g. As shown in Display 11, the 5% unitrust actually creates significantly less personal wealth than the higher unitrust percentages over very long time horizons (such as 40 years) due to the near total loss of the $3.4 million income tax deduction benefit. The 8% unitrust, given its better balance between the near total loss of the $1.8 million income tax deduction and the higher tax-deferral benefit, maximizes personal wealth over a 40-year period. Display 11 h. As in the publicly traded stock case study, a key assumption in the artwork case study is the donor s cost basis. In the stock case study, the value of the income tax deduction was the same regardless of the donor s cost basis. As the cost basis in the stock case study increased, the odds of reaching crossover decreased as a result of there being less benefit from tax deferral versus the outright taxable sale. With artwork, as the cost basis increases, so too does the charitable income tax deduction. 19

21 i. As illustrated in Display 12, the odds of reaching crossover by year 25 are initially higher for the donor funding with artwork relative to the donor funding with stock. This is due to the larger tax-deferral benefit on the higher collectibles tax rate versus the long-term capital gains tax rate. ii. As the cost basis of the asset increases, the odds that the donor funding with artwork will reach crossover by year 25 drop below the odds of the donor funding with stock. This is because there is not enough gain deferred to overcome the lower income tax deduction relative to the CRUT funded with stock. iii. Once the cost basis of the assets contributed reaches a certain level, the balance between the higher tax deferral on the collectibles tax rate and the benefit of the income tax deduction will again give the donor funding with artwork better odds of reaching crossover by year 25 than the donor funding with stock. Display 12 20

22 VII. Qualified Retirement Plan Case Study a. When a child or other non-spouse beneficiary inherits an IRA or other qualified retirement plan, the beneficiary is required to take annual increasing distributions over his or her lifetime according to required minimum distribution (RMD) rules. IRAs and qualified plans are considered income in respect of a decedent (IRD) and are therefore not entitled to a step-up in cost basis at the death of the account owner. 23 The distributions from an IRA are taxed as ordinary income when received by the beneficiary. The ordinary income tax rate on qualified plan assets can be as high as 45.5% 24 for a Minnesota resident. If the IRA was subject to federal estate taxes, then the beneficiary may be entitled to an IRC Section 691(c) deduction (IRD deduction) equal to the federal estate taxes that were paid at the owner s death. The IRD deduction is taken on a prorated basis of each distribution from the IRA. 25 b. Given that the qualified retirement plan may be subject to estate taxes, and distributions are taxable as ordinary income to beneficiaries without the benefit of a step-up, qualified retirement plans are often a prime choice for charitable bequests. Assets in an individual retirement account or other qualified retirement plan can be transferred to a CRT at the death of the account owner without having a taxable distribution. In addition, the estate is entitled to an estate tax charitable deduction equal to the present value of charity s remainder interest. c. In Private Letter Ruling (October 8, 1998), the IRS ruled that qualified retirement plan assets retain their character as IRD and ordinary income, falling into the first tier within the CRT accounting tiers. Furthermore, the ruling held that the IRD deduction reduces the amount included within the first tier but that the deduction is not directly made available to the noncharitable income beneficiary. Therefore, the benefit of the IRD deduction within a CRT is a reduction in the size of the initial amount retained within the ordinary income tier. When distributed to the noncharitable beneficiary, the ordinary income retained within tier one, comprising the initial amount received from the qualified retirement plan, is not subject to the 3.8% NIIT. However, subsequent growth or income realized within the CRT is included in NII when distributed to the noncharitable beneficiary, and therefore may be subject to the 3.8% NIIT. d. Assumptions and Facts: In the following case study, we compare a CRUT funded with a $10 million IRA at the owner s death to an inherited IRA for a 55-year-old non-spouse beneficiary, residing in Minnesota. 23 IRC 1014(c) 24 Assumes deduction for state income taxes paid. 25 IRC 691(c)(2) 21

23 i. We further assume that the beneficiary is entitled to a $3.4 million IRD deduction on IRA distributions due to the federal estate tax liability on the IRA. ii. In the CRUT scenario, we assume the estate receives an estate tax charitable deduction with an economic value worth $1.6 million in the 5% unitrust case, and $900,000 in the 8% unitrust case. We also assume the IRD deduction is netted against the first tier s accounting income from the IRA distributions to the CRT. iii. In both scenarios, we assume an allocation of 60% globally diversified equities 26 and 40% intermediate-term bonds. e. As shown in Display 13, over 30 years we forecast that the 5% and 8% CRUTs would result in $2.2 million and $1.7 million less personal wealth than the inherited IRA, respectively. This is because with the CRUT, the benefit provided by the estate tax deduction does not fully offset the loss of the direct benefit from the IRD deduction. Essentially, the IRA beneficiary is able to apply a prorated portion of the IRD deduction to each distribution received from the IRA, whereas with the CRUT, any benefit from the IRD deduction isn t realized for many years into the future. i. Another factor contributing to the higher relative personal wealth of the inherited stretch IRA is that for a 55-year-old beneficiary, the RMD is less than 5% for the first 10 years, and it isn t until the 20th year that the RMD exceeds 10%. This lower initial distribution allows for greater tax deferral than the CRUT. ii. As in the other cases we examined, the 5% CRUT maximizes both charity s remainder interest and total wealth. 26 The allocation to stocks is 21% US diversified, 21% US value, 21% US growth, 7% US small- and mid-cap, 22.5% developed international, and 7.5% emerging market. 22

24 Display 13 f. However, what if Congress changes the rules regarding inherited IRAs, so that designated beneficiaries are not eligible to stretch distributions over their lifetime? Such legislation has been proposed, and these proposals would have required the entire account balance of the qualified retirement plan to be distributed within five years of the original owner s death. i. As Display 14 illustrates, under a five-year rule the advantage of the inherited IRA over the CRUT would nearly be cut in half, declining from $2.2 million to $1.2 million with the 5% unitrust, and from $1.7 million to $700,000 with the 8% unitrust. Even if the five-year rule was to come to pass, the additional tax deferral within the CRUT in conjunction with the estate tax deduction is still not enough to overcome the more immediate benefit provided by the IRD deduction for the inherited IRA. 23

25 Display 14 g. Now what if there were no federal estate taxes paid and, as a result, no IRD deduction? We examine such a case for a Minnesota resident who has a $5.93 million estate. After paying the Minnesota state estate tax with non-ira assets, the non-spouse beneficiary is left with a $5.43 million IRA. In this case, the Minnesota estate taxes paid reduce the size of the estate sufficiently to eliminate any federal estate taxes, and as a result there is no IRD deduction. i. In the CRUT scenarios, the estate still receives a state estate tax charitable deduction worth about $210,000 in tax savings for the 5% unitrust scenario, and about $120,000 in tax savings for the 8% unitrust scenario This represents the actual reduction in state estate taxes paid as a result of the charitable estate tax deduction. 24

26 ii. As shown in Display 15, the gap in personal wealth between the inherited stretch IRA and the CRUT is much narrower for the 8% unitrust and somewhat narrower for the 5% unitrust under these circumstances than in the previous case study. iii. Under the five-year rule, the CRUT actually produces about a $300,000 advantage to personal wealth in the 8% unitrust scenario relative to the inherited IRA, and only about a $300,000 gap in the 5% unitrust scenario. iv. As in the other cases we examined, the 5% CRUT maximizes both charity s remainder interest and total wealth. Display 15 25

27 APPENDIX Notes on Wealth Forecasting System 1. Purpose and Description of Wealth Forecasting System Bernstein s Wealth Forecasting System SM is designed to assist investors in making long-term investment decisions regarding their allocation of investments among categories of financial assets. Our planning tool consists of a four-step process: (1) Client Profile Input: the client s asset allocation, income, expenses, cash withdrawals, tax rate, risk-tolerance level, goals, and other factors; (2) Client Scenarios: in effect, questions the client would like our guidance on, which may touch on issues such as when to retire, what his/her cash-flow stream is likely to be, whether his/her portfolio can beat inflation long term, and how different asset allocations might impact his/her long-term security; (3) The Capital Markets Engine: Our proprietary model, which uses our research and historical data to create a vast range of market returns, takes into account the linkages within and among the capital markets, as well as their unpredictability; and finally (4) A Probability Distribution of Outcomes: Based on the assets invested pursuant to the stated asset allocation, 90% of the estimated ranges of returns and asset values the client could expect to experience are represented within the range established by the 5th and 95th percentiles on box and whiskers graphs. However, outcomes outside this range are expected to occur 10% of the time; thus, the range does not establish the boundaries for all outcomes. Expected market returns on bonds are derived taking into account yield and other criteria. An important assumption is that stocks will, over time, outperform long bonds by a reasonable amount, although this is in no way a certainty. Moreover, actual future results may not meet Bernstein s estimates of the range of market returns, as these results are subject to a variety of economic, market, and other variables. Accordingly, the analysis should not be construed as a promise of actual future results, the actual range of future results, or the actual probability that these results will be realized. 26

28 2. Capital-Market Projections: Next 40 Years Median 40-Year Growth Rate Mean Annual Return Mean Annual Income 1-Year Volatility 40-Year Annual Equivalent Volatility Int.-Term Diversified Municipal Bonds 3.7% 4.0% 3.8% 3.6% 9.9% US Diversified 7.2% 9.0% 3.0% 16.4% 23.3% US Value 7.5% 9.2% 3.6% 16.0% 22.8% US Growth 6.9% 9.0% 2.5% 18.2% 24.8% US Small-/Mid-Cap 7.3% 9.5% 2.7% 18.7% 25.4% Developed International 7.9% 10.1% 3.3% 18.1% 24.0% Emerging Markets 6.1% 10.1% 4.1% 26.1% 30.9% Inflation 3.0% 3.4% n/a 1.0% 13.2% Based on 10,000 simulated trials each consisting of 40-year periods. Reflects Bernstein s estimates and the capital-market conditions of March 31, Does not represent any past performance and is not a guarantee of any future specific risk levels or returns, or any specific range of risk levels or returns. 3. Rebalancing Another important planning assumption is how the asset allocation varies over time. We attempt to model how the portfolio would actually be managed. Cash flows and cash generated from portfolio turnover are used to maintain the selected asset allocation between cash, bonds, stocks, REITs, and hedge funds over the period of the analysis. Where this is not sufficient, an optimization program is run to trade off the mismatch between the actual allocation and targets against the cost of trading to rebalance. In general, the portfolio allocation will be maintained reasonably close to its target. In addition, in later years, there may be contention between the total relationship s allocation and those of the separate portfolios. For example, suppose an investor (in the top marginal federal tax bracket) begins with an asset mix consisting entirely of municipal bonds in his/her personal portfolio and entirely of stocks in his/her retirement portfolio. If personal assets are spent, the mix between stocks and bonds will be pulled away from targets. We put primary weight on maintaining the overall allocation near target, which may result in an allocation to taxable bonds in the retirement portfolio as the personal assets decrease in value relative to the retirement portfolio s value. 4. Expenses and Spending Plans (Withdrawals) All results are generally shown after applicable taxes and after anticipated withdrawals and/or additions, unless otherwise noted. Liquidations may result in realized gains or losses that will have capital gains tax implications. 27

29 5. Modeled Asset Classes The following assets or indexes were used in this analysis to represent the various model classes: Asset Class Modeled as Annual Turnover Rate Intermediate-Term Diversified Municipal Bonds Intermediate-Term Taxable Bonds AA-rated diversified municipal bonds of 7-year maturity 30% Taxable bonds of 7-year maturity 30% US Diversified S&P 500 Index 15% US Value S&P/Barra Value Index 15% US Growth S&P/Barra Growth Index 15% Developed International MSCI EAFE Unhedged Index 15% Emerging Markets MSCI Emerging Markets Index 20% US Small-/Mid-Cap Russell 2500 Index 15% 6. Volatility Volatility is a measure of dispersion of expected returns around the average. The greater the volatility, the more likely it is that returns in any one period will be substantially above or below the expected result. The volatility for each asset class used in this analysis is listed in the Capital-Market Projections section above. In general, two-thirds of the returns will be within one standard deviation. For example, assuming that stocks are expected to return 8.0% on a compounded basis and the volatility of returns on stocks is 17.0%, in any one year it is likely that two-thirds of the projected returns will be between (8.9)% and 28.0%. With intermediate government bonds, if the expected compound return is assumed to be 5.0% and the volatility is assumed to be 6.0%, two-thirds of the outcomes will typically be between (1.1)% and 11.5%. Bernstein s forecast of volatility is based on historical data and incorporates Bernstein s judgment that the volatility of fixed income assets is different for different time periods. 7. Technical Assumptions Bernstein s Wealth Forecasting System is based on a number of technical assumptions regarding the future behavior of financial markets. Bernstein s Capital Markets Engine is the module responsible for creating simulations of returns in the capital markets. These simulations are based on inputs that summarize the current condition of the capital markets as of March 31, 2015, which may not coincide with the beginning of a calendar year. A description of these technical assumptions is available on request. 28

30 8. Tax Implications Before making any asset allocation decisions, an investor should review with his/her tax advisor the tax liabilities incurred by the different investment alternatives presented herein, including any capital gains that would be incurred as a result of liquidating all or part of his/her portfolio, retirement-plan distributions, investments in municipal or taxable bonds, etc. Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions. 9. Income Tax Rates Bernstein s Wealth Forecasting System has used various assumptions for the income tax rates of investors in the case studies in this outline. See the assumptions in each case study (including footnotes) for details. Contact Bernstein for additional information. The federal income tax rate is Bernstein s estimate of either the top marginal federal income tax rate or an average rate calculated based upon the marginal-rate schedule. The federal capital gains tax rate is the lesser of the top marginal federal income tax rate or the current cap on capital gains for an individual or corporation, as applicable. Federal tax rates are blended with applicable state tax rates by including, among other things, federal deductions for state income and capital gains taxes. The state tax rate generally is Bernstein s estimate of the top marginal state income tax rate, if applicable. The Wealth Forecasting System uses the following top marginal federal tax rates unless otherwise stated: in 2015, a federal ordinary income tax rate of 39.6% and a federal capital gains tax rate of 20%. 10. Required Minimum Distributions The law does not permit funds to remain in a tax-deferred account indefinitely. Beginning in the year in which an IRA owner or participant in a qualified retirement plan a 401(k) plan, for example turns 70½, he or she must withdraw a minimum amount from the account each year.* This amount is known as the minimum required distribution (MRD). The MRD rules are complex and, in some cases, even uncertain. After an account owner s death: 1. Spouse: If an account owner designates his or her spouse as his or her beneficiary, a special rule applies: A spouse may roll over an inherited IRA into an IRA in his or her own name. The spouse becomes the account owner for purposes of the MRD rules. As a result, MRDs during his or her lifetime are based on the Uniform Lifetime Table, just as if he or she had established the account. 2. Non-Spouse Individuals: If the account owner names his or her child as the beneficiary, the MRD for the year after the original owner dies is the value of the account at the end of the year in which that owner died, divided by the child s remaining life expectancy under the IRS s Single Life Expectancy Table. In each subsequent year, the divisor is simply reduced by one. 29

31 3. Non-Individual: If a non-individual is the beneficiary of the account (e.g., the owner s estate), MRDs depend on whether the owner died before or after his or her required beginning date (RBD), which is typically April 1 of the year following the year in which the owner turns 70½. If the owner dies after his or her RBD, distributions are based on the owner s remaining life expectancy (determined as described above). However, if the owner dies before his or her RBD, the entire account must be distributed no later than the end of the fifth year after the year in which the account owner dies. a. Note: Under certain circumstances, if a trust is named as the beneficiary, the beneficiaries of the trust (and not the trust itself) will be treated as having been designated as beneficiaries of the account for purposes of determining MRDs. Investors should always consult their legal and tax advisors on any issues relating to MRDs. *If the account owner wishes, he or she can delay the distribution for the year in which he or she turns 70½ until April 1 of the following year. In addition, in certain cases, a participant in a qualified retirement plan (but not an IRA owner) can delay distribution until April 1 of the year after the year in which the participant retires, even if he or she continues to work past age 70½. 30