• A charitable remainder annuity trust (CRAT) is a type of irrevocable trust that provides a fixed annual income to the donor or beneficiaries, with the remaining assets going to a chosen charity.
• Establishing a CRAT can provide significant tax advantages for the donor, such as an immediate income tax deduction, reduced estate taxes, and avoidance of capital gains taxes on appreciated assets.
• A CRAT can be funded with various types of assets, including cash, stocks, bonds, real estate, and closely-held business interests.

Charitable remainder annuity trusts (CRATs) enable individuals to support their preferred charitable organizations while also receiving a fixed income stream for a specific period. A CRAT can be funded with traditional investments such as cash, stocks, bonds, or real estate.

How CRATs work

A CRAT is a planned giving strategy that allows individuals to support their chosen charity while also receiving income during their lifetime. In order to establish a CRAT, an individual creates a trust, transfers assets into it, and designates a charity as the remainder beneficiary.

The main components of a CRAT include the grantor, the trust, the annuity payments, and the designated charity. The trustee and the charity serve as necessary counterparties in the CRAT structure. A CRAT can provide tax benefits for the grantor, such as an immediate income tax deduction, potential reduction in estate taxes, and an avoidance of immediate capital gains tax once the asset is sold inside of the CRAT. It also allows the grantor to support a cause they care about while receiving a steady income during their lifetime.

Establishing a CRAT

Once the individual, known as the grantor (or donor), transfers assets such as cash, stocks, or real estate into the trust, which are managed and invested by a third-party trustee in order to generate income.

While the gifted assets are removed from the grantor’s estate, the CRAT pays him or her a fixed income, called an annuity, for the grantor’s lifetime (or a specified time period), not to exceed 20 years. The annuity amount is determined at the time the trust is created and is based on a percentage of the initial value of the trust's assets. Annual distributions from the trust must amount to at least 5% but no more than 50% of the original value of the trust asset. 

Annuity payments received by the grantor are subject to income tax using a four-tiered accounting system. At the end of the specified period or the grantor's life, the remaining assets in the trust are transferred to a designated charity.

The role of life insurance with a Charitable Remainder Annuity Trust

If the grantor wishes, he or she can also establish a secondary Wealth Replacement Trust (WRT), which is a type of Irrevocable Life Insurance Trust (ILIT), that owns a life insurance policy on the grantor. In this scenario, the annual income provided by the CRAT is received by the grantor and is then gifted to the WRT to pay the life insurance premiums on the policy.

The beneficiary(ies) of the WRT would receive the entire amount of the death benefit proceeds once the grantor passes away. The amount of life insurance can either be just enough to replace the value of the donated asset or can be maximized using the entire amount of net income provided by the CRAT.  

Product selection

Two common types of life insurance policies that can be used for a WRT, if utilized, are whole life insurance and universal life insurance.

Whole life insurance provides a guaranteed death benefit, level premiums, and a cash value component that grows over time. This type of policy can be suitable for a WRT due to its stability and guaranteed benefits. However, whole life insurance policies tend to have higher premiums compared to other types of life insurance.

Universal life insurance - including current assumption, indexed, and variable products - offers more flexibility in terms of premium payments, death benefits, and cash value accumulation. This type of policy allows the grantor to adjust the premium payments and death benefit amounts as needed. However, the cash value and death benefit are not guaranteed, as they depend on the performance of the investments within the policy.

Both whole life and universal life insurance policies can be effective options for funding a WRT, depending on the grantor's financial goals, risk tolerance, and desired level of flexibility. It is crucial to carefully evaluate the features and potential outcomes of each policy type before making a decision.

Case study

Bob, age 50, is single with two children and owns a significant amount of real estate that is highly-appreciated. He also places a high value on giving back to charity. Bob plans to ultimately leave the property to his children when he passes, but he would also like a steady stream of income over the next few years. 

After a discussion with his advisor, Bob decides to transfer $1,000,000 worth of real estate to a CRAT. The trustee of the CRAT sells the asset. Although Bob’s cost basis is only $500,000, he is able to avoid immediate capital gains tax on the sale. The CRAT will provide Bob with an annual payout of 5%, or $50,000 per year, for the next 10 years. 

Bob also establishes a Wealth Replacement Trust (WRT) that owns a life insurance policy for $1,000,000 on his life. The premium required to provide lifetime guaranteed coverage over a 10-year period is $25,110.* Bob uses a portion of the CRAT income each year to gift to the WRT and can use any after-tax residual income for personal use. His children are beneficiaries of the WRT and will ultimately receive $1,000,000 tax-free at Bob’s passing. At the end of the CRAT term of 10 years, Bob’s named charity would still receive approximately $855,927.

Additional considerations

Administration and compliance

A CRAT requires a well-structured trust document, reliable trustee, and careful adherence to the guidelines set by the Internal Revenue Service (IRS). The trustee is responsible for managing the trust assets, making annual annuity payments to the income beneficiaries, and distributing the remaining assets to the designated charity upon the trust's termination.

Tax considerations

A CRAT offers several tax benefits, including income tax deductions, avoidance of capital gains tax, and potential estate tax savings. When an individual contributes assets to the trust, they may be eligible for an income tax deduction based on the present value of the remainder interest that will eventually go to the charity. Transferring appreciated assets to the CRAT can help minimize capital gains tax on the sale of those assets. 

Because the remaining trust assets will be distributed to a charity, the value of those assets will not be included in the grantor’s estate, potentially reducing estate tax liability.

* Based on a lifetime guaranteed universal life policy with Nationwide on a male, age 50, preferred nonsmoker.

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