What Is a Charitable Lead Annuity Trust (CLAT)?
CLATs are trusts that allow you to donate assets in exchange for an immediate tax deduction.
How It Works:
- You gift some of your income to the trust and get a charitable deduction up to the entire value you donated.
- You reinvest the cash in other assets during the term of the trust.
- Every year, the trust donates a predetermined amount to a recognized charity.
- At the end of the trust’s term, you or your beneficiary receive the remaining trust assets.
Why It Works
The tax mitigation arbitrage comes from two areas:
- The difference in the government’s assumed growth rate of assets - 3% as of May 2022 - and the
returns generated by the investments in the trust. The government is discounting your charitable
deductions assuming a 3% growth rate, and as a result you receive a large charitable deduction
and also capture the growth above that rate minus your charitable donation.
- Writing off ordinary income or short-term capital gains now and then paying a lower tax rate as
long-term capital gains when you pay taxes in the future.
What happens while the trust is operating?
Every year, the trust will make a small donation to the charity of your choice. Following the IRS’s prescribed procedure, that small donation to charity will start in the low four figures and grow 20%per year (ie. a $1m CLAT will donate $1,824,000 over 25 years). The key is that, by taking the deduction on day 1 and deferring the majority of the donation, you get to reinvest and grow your money for 25 years. Thus in this $1m example, in the final year, you will receive all of the assets remaining in the trust — about $4.7 million on a pre-tax basis. Moreover, you won’t necessarily have to pay taxes on that amount on the day the trust ends; the trust can distribute the assets in kind, and you can continue to let them grow in the market until you need the liquidity.
Quantifying the Savings
- You could earn $1,200,000 more with a CLAT
- Additional return: 34%
- Money donated to charity: $1,800,000
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