Annuity Riders in Charitable Remainder Trusts (CRT) Kenneth Boothe, JD, CLU, ChFC Director, Advanced Consulting Group

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1 Annuity Riders in Charitable Remainder Trusts (CRT) Kenneth Boothe, JD, CLU, ChFC Director, Advanced Consulting Group Generally, the order of events in establishing a CRT begins with transferring the assets to be gifted into the trust after the trust has been drafted by an attorney. At that point, the named trustee has some decisions to make. One of the biggest and most pressing decisions to make is how to make the assets productive. CRT s need to contain income producing property to be able to make the promised payments to the grantor(s). If the assets are already producing income, such as rental property, the trustee may have to do nothing. If instead, the assets are highly appreciated securities or non-income producing real estate, as is often the case, the trustee may need to liquidate these assets. Where is the best place to invest the proceeds? Many people make the argument that the best place to invest these sale proceeds is in individual mutual fund accounts. The argument goes that since the CRT does not pay taxes anyway, it doesn t need the protection of a tax sheltered vehicle. While that is true, it is only part of the equation. The other part of the equation deals with assurances that there will still be sufficient assets to pay the donors the income they are due for the rest of their lives and/or that the charity will still have something left. A charitable trustee is generally given broad latitude with respect to investments to achieve the goal of lifetime income. One popular investment option involves the use of non-qualified annuities. This article will look at these different charitable vehicles and how the riders available on Nationwide annuities may be successfully used. Keep in mind that even though a charitable trust income payout can be based on joint life expectancy, the Nationwide Joint Lifetime Income Rider (L.inc) is not available for use in a charitable remainder trust. Similarly, the Spousal Protection death benefit feature is unavailable on contracts owned by CRT s. The two main types of riders discussed here are the Lifetime Income Rider and the Death Benefit Options. The following are some applications of annuities in CRT s. 1

2 Charitable Remainder Annuity Trust (CRAT) The CRAT is designed to function more like a traditional payout annuity, hence the name. The CRAT pays a fixed dollar amount to the grantor throughout the existence of the trust. This amount is set when the trust is established, and will not fluctuate no matter how the underlying investments perform. While this is an option that gives your client certainty in the amount that they will receive, it fails to address the effect that negative market performance will have on the account. It is possible that the charity will be left with little or nothing of the original gift. CRAT s fit well with the Linc component of the Nationwide annuity, which guarantees a fixed payment (assuming no excess withdrawals) for the life of the donor. This decreases the likelihood of running out of money for long-lived donors. Death Benefit Options Enhanced death benefits can be chosen, but would seem unlikely to offer any real value. The standard death benefit (return of premium) is most likely the way to go here, since withdrawals are being taken from the outset of the contract, and withdrawals reduce death benefit proportionally. Net Income With Make-up Charitable Remainder Unitrust (NIMCRUT) A NIMCRUT is a charitable trust that pays a unitrust payment but allows more flexibility in the payout of income. The NIMCRUT pays to the donor the lesser of a fixed percentage of the trust assets valued annually, or the net income of the trust for the current year. A make-up account is created in any year that income earned is less than the fixed percentage allowed. This make-up account is then paid out at a later date, usually at the donor s retirement when the trust has sufficient income to make the payments. Since the growth in an annuity is not considered income, the donor can defer trust payments for long periods and the make-up account can grow quite large. Many advisors ask if the L.inc rider is a fit in a NIMCRUT. Given the fact that significant excess withdrawals are likely to be taken from the annuity and the fact that excess withdrawals reduce future L.inc guaranteed payments, the rider may end up not providing much benefit, relative to its cost. 2

3 Death Benefit Options This is the situation in which the enhanced death benefit options can really shine. Due to the fact that many years may pass between the initial gift/investment and the subsequent payout, the increase in death benefit can be significant. The greater the length of time between initial investment and withdrawal, the greater likelihood of having a larger death benefit. This is great news for the named charity, as it could receive a greater amount than it otherwise would on the death of the donor. Charitable Remainder Unitrust (CRUT) The mechanics of establishment are essentially the same as the CRAT, but the operation and administration are very much different. Instead of receiving a fixed dollar amount every year, the client receives a fixed percentage of the value of the account every year. The client is allowed to share in market gains and has upside potential if the investments do well. The downside is that the distribution will decrease if the investment suffer losses. This can help provide inflation protection and maintain purchasing power. If the client receives a portion of the value of the account every year, that necessarily means the client will receive a lesser payment in down years. If there are enough bad years in a row, the client could face significant reductions in income, thereby altering their planned lifestyle. Since the likelihood of taking excess payments from an annuity with L.inc is increased, it decreases the likelihood that the lifetime income rider would provide any sustainable real value. Death Benefit Options As with the CRAT, enhanced death benefits can be chosen, but would seem unlikely to offer any real value, since withdrawals are being taken from the outset of the contract, and withdrawals reduce death benefit proportionally. General Features and Operations of CRT s Typically, the donor receives an immediate income tax deduction for the present value of the charity s remainder interest. Further, the donor may avoid a lump sum capital gains tax bill if the property given is an appreciated capital asset when the trustee sells the property. The trustee is charged with making the property productive (i.e. income producing). At some point, the trustee is tasked with providing income to the donor for life. Any amounts that remain when the donor dies will be paid to the charity and the trust will end. However, a few rules must be followed to ensure that both the charity and the donor receive some level of protection. 3

4 Generally, the donor will receive at least a 5% payout of the trust value every year. Similarly, the charity must be expected to receive at least 10% of the beginning balance as a remainder. Both these numbers are based on actuarial tables and are calculated only at the beginning of the trust term. If, through other factors (such as negative market performance), the charity does not actually receive at least 10% at the end of the trust term, there is no negative consequence to the donor as long as the calculation was accurate when the trust began. With respect to the income from the CRT, the income will retain the same character to the grantor as it had when received by the trust. However, I.R.C. Section 664 established ordering rules for the deemed distribution of income. First, the trust must distribute ordinary income to the extent that the trust has ordinary income for the current year, as well as any undistributed ordinary income in prior years. Unused ordinary income is carried over into successive years. Note that all income received from an annuity is ordinary income. Second, any distributions in excess of ordinary income will be deemed a distribution of capital gains, to the extent that the trust has them and they have not been previously distributed. Third, if the distributions exceed both ordinary income and capital gains, the trust may distribute other income, such as tax exempt income, to the extent that the trust has it and has not been previously distributed. Lastly, if the distribution is in excess of all the above, the distribution is deemed a non-taxable return of basis. Due to these multiple layers of accounting, CRT s can get a bit complicated. Even if an annuity is the only investment in the trust, there still may be a scenario where the cost basis being distributed will be income taxable because of the stored, but undistributed taxation within the trust. In summary, it is clear that annuities can have a place in charitable planning. Generally speaking, living benefits could be successfully used in a CRAT scenario, and enhanced death benefits could be useful in a NIMCRUT scenario. As with most things, there may be other facts and circumstances that change this general rule. When evaluating the purchase of a variable annuity, your clients should be aware that variable annuities are long-term investment vehicles designed for retirement purposes and will fluctuate in value; annuities have limitations; and investing involves market risk, including possible loss of principal. 4

5 Federal income tax laws are complex and subject to change. The information in this memorandum is based on current interpretations of the law and is not guaranteed. Neither Nationwide, nor its employees, its agents, brokers or registered representatives gives legal or tax advice. You should consult an attorney or competent tax professional for answers to specific tax questions as they apply to your situation. Nationwide and the Nationwide framemark are registered service marks of Nationwide Mutual Insurance Company. Nationwide Financial Services, Inc. All rights reserved. Nationwide Investment Services Corporation, Columbus, Ohio, member FINRA. NFM-12056AO 5