Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How Early Retirees Use a Charitable Remainder Trust
Transcript
- Lucas: So, Luna, we've talked a lot about sequence risk, withdrawal rates, and even tax-efficient strategies like Roth ladders and tax-loss harvesting. But there's one tool that I think we haven't covered yet, and it's perfect for a listener who has a big chunk of their net worth tied up in one highly appreciated stock. Luna: Oh, you mean the person who bought Apple back in 2010 and now has a million-dollar position that they're terrified to sell because of the tax bill? Lucas: Exactly. And honestly, that's a really common problem for early retirees. You've built this nest egg, but it's concentrated in a single asset that's been a huge winner. Selling it would trigger a massive capital gains tax event, and that could push you into a higher bracket and mess with your ACA subsidies. Luna: Right. So what's the alternative? Just hold on to it and hope it doesn't crash? Lucas: Well, one alternative is what's called a charitable remainder trust. It's a strategy that lets you donate the asset to a trust, get a charitable income tax deduction for a portion of the value, and then receive a stream of income from that trust for the rest of your life, or for a set number of years. Luna: I've heard of these, but they always sound so complicated. Can you break it down for us? Lucas: Sure. So, you fund the trust with the appreciated asset. The trust then sells the asset, but because it's a charitable trust, it doesn't pay capital gains tax. Instead, the proceeds are reinvested, and the trust pays you a percentage of the value each year based on the trust agreement. Luna: So you effectively diversify without the tax hit. But what about the charitable deduction? How does that work? Lucas: When you fund the trust, you get an immediate deduction for the present value of the remainder interest that will eventually go to charity. It's not the full value of the asset, but it can be a significant deduction, especially if you're in a high tax bracket and the trust is set up to pay you a lower income. Luna: And speaking of listener support, if these deep dives into niche tax strategies are helping you get more confident in your retirement plan, consider supporting the show at buy me a coffee dot com slash fexingo. It's a simple way to keep this podcast ad-free. Lucas: Yeah, we appreciate that. It really helps us keep doing these episodes. So, back to the trust. There are two main types: a charitable remainder annuity trust, which pays a fixed dollar amount each year, and a charitable remainder unitrust, which pays a percentage of the trust's value each year, so it can fluctuate. Luna: And which one would an early retiree typically choose? Lucas: Often, a unitrust, because it provides a hedge against inflation. If the trust grows, your income grows. But there's a trade-off: your income can also drop in down years, which might not be ideal if you're relying on it for living expenses. Luna: So for someone like our hypothetical Apple shareholder, how would this actually play out? Let's say they have a million dollars in stock with a cost basis of two hundred thousand dollars. Lucas: If they sell directly, they'd owe capital gains on eight hundred thousand. At the top federal rate, that's around a hundred and sixty thousand, plus state taxes and possibly the net investment income tax. That's a huge bite. But if they put that stock into a CRT, the trust sells it tax-free, reinvests, and pays them an income for life or a term of years. Luna: And what kind of income could they expect? Lucas: Well, the payout rate is set when you create the trust, and it's typically between five and eight percent of the trust's value each year. So on a million dollars, that could be fifty to eighty thousand dollars a year in income, which is a nice supplement to other retirement income. Luna: But that income is taxable, right? It's not like a Roth distribution. Lucas: Right. The income is taxed as ordinary income to the extent that it's from interest or dividends, and as capital gains if the trust sells assets for a gain. But the point is, you're spreading the tax hit over many years instead of paying it all at once. Luna: And you're also benefiting a charity. It's like a win-win. Lucas: It can be. But it's not for everyone. There are some significant trade-offs. The trust is irrevocable, meaning you can't change your mind and get the asset back. And once you fund it, you're committed to the income stream and the charity. Luna: So you really need to be sure you're comfortable with that. Lucas: Absolutely. And there's also the complexity and cost of setting up and administering the trust. You'll need a trustee, which could be a financial institution or an individual, and they'll charge fees. So it makes sense to use a CRT when you have a large enough asset to justify the costs. Luna: Is there a minimum threshold? Like, would it work for a hundred thousand dollar portfolio? Lucas: Probably not. The IRS doesn't set a minimum, but the setup and administrative costs would eat into the benefits. I'd say you'd want at least five hundred thousand dollars' worth of appreciated assets to make it worthwhile. And even then, you need to have a charitable intent. Luna: That's a good point. The charity has to be a qualified organization. You can't just name your best friend. Lucas: Right, it has to be a recognized 501 charity. But you can choose any charity you like, or even set up a donor-advised fund to recommend grants over time. We talked about donor-advised funds in a previous episode, and they can work together nicely. Luna: So, how does this fit into our broader retirement decumulation strategy? We've talked about buckets, guardrails, and sequence risk. Where does a CRT fit in? Lucas: I see it as a tool for the 'too much in one basket' problem. If you have a concentrated position, a CRT can help you diversify without taking a huge tax hit upfront, and it can also provide an income stream that's not directly tied to the market, if you choose an annuity trust. Luna: But with a unitrust, your income could fluctuate, which could actually increase sequence risk. Lucas: Exactly. That's why it's important to think about the rest of your portfolio. A CRT shouldn't be your only income source. It should be part of a broader plan that includes a cash reserve and other diversified investments. Luna: So, is this something our listeners could set up themselves, or do you really need professional help? Lucas: Definitely professional help. This is not a DIY project. You need an attorney who specializes in estate planning and a financial advisor who understands CRTs. The tax rules are complex, and mistakes can be costly. Luna: What about the impact on ACA subsidies? We mentioned that earlier. Lucas: Good catch. The income from a CRT counts as income for MAGI, which affects your subsidies. But here's the thing: because you're spreading the income over many years, it might keep you below the subsidy cliff compared to a one-time capital gain. Luna: So it could actually help you maintain affordable healthcare in early retirement. Lucas: Potentially, yes. But you'd want to model it carefully, because the trust's income can vary from year to year, especially with a unitrust. That could push you over the threshold in a good year. Luna: So, to wrap up, a charitable remainder trust is a sophisticated tool that can help with tax diversification, income generation, and charitable giving—but it's not for everyone. Lucas: Right. It's most useful for those with a large, highly appreciated asset and a genuine desire to support a cause. If you fall into that category, it's worth exploring. Otherwise, simpler methods like a direct sale and tax-loss harvesting might be more appropriate. Luna: And as always, we're not financial advisors. This is for educational purposes. Definitely consult a professional before making any big decisions. Lucas: Absolutely. But it's a fascinating tool, and I'm glad we could shine a light on it for episode 150. Thanks for listening, and we'll be back with more strategies next week. Luna: Until then, happy planning!