How Charitable Contributions Can Reduce Your Estate Taxes

December 01, 2016

A few weeks ago, I wrote about whether you might have a taxable estate. If you’re unfortunate (or fortunate) enough to have an estate large enough to be subject to estate taxes, there are several ways you can reduce that liability while helping your favorite charity. Here are a couple of the most common:

Lifetime giving. If you give assets away before you die, they can reduce the total amount that you can pass on estate-tax free at death. For example, you can pass on $5.45 million (twice that as a married couple) tax-free in 2016. If you give away $1 million, your $5.45 million exemption is reduced by that $1 million to $4.45 million. Otherwise, people could easily give away their entire estate tax-free on their death bed.

There are a few exceptions to this though. One is that you can give away $14,000 per person to an unlimited number of people per year without reducing your estate tax exemption.  (You can use up to 5 years of that $14,000 exemption upfront by gifting it to a 529 education savings plan.) Another exception is for gifts made to charitable organizations. You can give an unlimited amount to charity while alive or at death without any estate or gift tax consequences.

Charitable remainder trust. A more sophisticated method is to use a type of irrevocable trust called a charitable remainder trust. In addition to reducing your estate taxes, this strategy can also reduce your income taxes and increase your after-tax investment income. That’s because you get a charitable deduction for the value of the assets donated to the trust, the trust can then sell the assets without a capital gains tax to pay you an income stream, and then the remainder is passed on to the charity estate tax-free at your death.

For example, let’s say that you have investments worth $1,000,000 that you originally purchased for $500,000. If you sold those investments and paid a 15% capital gains tax, you’d end up with $425,000 after-tax. If you earned  a 4% income from that, you’d have $17,000 of investment income.

On the other hand, if you donated the $1,000,000 of assets to a charitable remainder trust, you’d get a deduction of the $1,000,000 donation from your income taxes. At the 35% tax bracket, that would be worth $350k in tax savings (plus $38k from the net investment surtax). In addition, the trust can sell the investments without a capital gains tax and pay you a 4% income from the full $1,000,000 which would be about $40,000 per year or $23,000 more annual income than you would otherwise be getting after the capital gains tax.

The big downside is that you wouldn’t be able to pass the remainder on to your heirs. However, you can replace that inheritance by purchasing life insurance inside an irrevocable life insurance trust. Since the trust is irrevocable, the life insurance proceeds would not be part of your taxable estate.

Of course, there are other strategies to reduce your estate taxes so if you have a taxable estate, you’ll want to speak to a qualified estate planning attorney to understand all of your options. The main point is that you can do well for yourself by doing well for others. Now if only I had a taxable estate to worry about…