How to Reduce Ordinary Income Tax With a CLAT
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
Savvy Advisors is a Registered Investment Advisor with the Securities Exchange Commission. This registration with the SEC does not constitute a professional specialty designation or endorsement. Savvy only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.Savvy does not provide tax or legal advice. Investors should work with their own professional (attorney, tax, insurance) regarding consequences, if any, as it relates to their circumstance and the applicability of any particular tax strategy.The information contained herein has been obtained from sources that are believed to be reliable. However, Savvy does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities.
Meet
Dan Perrino
Hello there! 👋🏼 I'm Dan, originally from Chicago and now residing in Bellingham, Washington. My lifelong passion for finance and the stock market has driven my career path.
How to Reduce Ordinary Income Tax With a CLAT
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
Savvy Advisors is a Registered Investment Advisor with the Securities Exchange Commission. This registration with the SEC does not constitute a professional specialty designation or endorsement. Savvy only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.Savvy does not provide tax or legal advice. Investors should work with their own professional (attorney, tax, insurance) regarding consequences, if any, as it relates to their circumstance and the applicability of any particular tax strategy.The information contained herein has been obtained from sources that are believed to be reliable. However, Savvy does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities.
Meet
Dan Perrino
Hello there! 👋🏼 I'm Dan, originally from Chicago and now residing in Bellingham, Washington. My lifelong passion for finance and the stock market has driven my career path.
