Case Studies and Articles

Partnering a CLAT and a Stretch IRA – Vaughn W. Henry & Associates

Partnering a CLAT and a Stretch IRA – Vaughn W. Henry & Associates

Partnering a CLAT and a Stretch IRA

Janet Bari (67), a professor emeritus of the local university’s art department, and her husband, Virgil (68), are typical Midwesterners.  They live modestly on $22,000 of social security income and what Janet makes by selling handmade jewelry and sculptures.   They own their country home, have no debts, pay cash for all of their purchases and avoid any sort of an ostentatious lifestyle.  She and Virgil married twenty years ago and each have children from previous marriages; both have a desire to preserve assets for their children, grandchildren and still provide for a degree of comfort and security in retirement.

Janet jumped onto the mutual fund bandwagon long before it became popular and regularly set aside savings in her IRA and 403(b) retirement plan, and has since accumulated over $1 million in tax deferred savings.  After realizing that she was also creating a potential IRD (income in respect of a decedent) tax trap, she redirected her on-going savings program to non-qualified equity accounts and has been pleased with the 14%+ returns over the last twelve years and her investment account has since grown to $500,000.  Always a big supporter of charitable causes, she and Virgil regularly give $5,000 to $15,000 away annually, even though their accountant has warned them that they can’t make complete use of the annual charitable deductions on their tax return.

When asked about goals and priorities, Janet said she hoped to leave each child with a level of financial support that wouldn’t be a disincentive to work, but would encourage heirs to develop their own business and philanthropical interests.  She wanted her family to receive the proceeds of her investment account, and although already making numerous $10,000 annual exclusion gifts, she was unwilling to make significant lifetime gifts to her heirs now and use up her applicable exclusion amount (unified credit).  Janet also expressed concern about helping a disabled granddaughter and a desire to protect her retirement plan assets from unnecessary taxation at death.

Of the many solutions proposed to her, the following scenario seemed to make the most sense.  It was easy to implement, provided a lot of flexibility and allowed her to make use of her retirement plan assets in a tax efficient fashion.  Since she hadn’t reached her required beginning date of 70½ years of age, Janet was able to take her $1 million in retirement plan assets and break the account up into seven different Individual Retirement Accounts (IRA) naming different family members as beneficiaries to each.  This strategy allowed her to have a longer payout when calculating the minimum required distributions (MRD), thus stretching out the payments over joint life expectancies that included some very young beneficiaries.  By stretching the payments out and by taking all the required distributions from just one $600,000 IRA account, the one she and her spouse shared, this allowed the six remaining accounts of $50,000 to $100,000 to continue compounding in a tax-deferred environment.  Since she was concerned about one granddaughter’s disability and future financial needs, Janet chose to fund that girl’s IRA at a higher level than those naming other grandchildren as beneficiaries.

Her advisor reminded her often that beneficiary designations can be modified, so if Janet has need of funds, she can always accelerate her withdrawals from any or all of her accounts, and this provides for adequate income security.  While Janet has no need of additional retirement income now, she has invested her seven IRA accounts in equity mutual funds and fully expects that they will continue to grow even after she’s forced to commence distributions.  She also named a charity to receive any balance in her primary IRA, limiting the IRD exposure while still providing for her husband, should he survive her.

To continue funding her charitable interests, a 5% non-grantor charitable lead annuity trust (CLAT) was established with the $500,000 investment account.  Since it has historically produced annual income and appreciation in excess of 14%, it was assumed that it could sustain a yearly gifting program of $25,000 and still have the capacity to grow over a twenty-year period of time.  The CLAT, a tax paying trust, can make charitable contributions and offset any earned income as a stand-alone taxable entity and make use of charitable deductions that Janet’s personal tax return cannot claim because of her AGI limitations.  By making distributions to a community foundation, Janet, as CLAT Trustee, can redirect the proceeds through a donor advised fund to charities of interest to the Bari family.  The foundation offers the Bari family the ability to accommodate any changes in their charitable contributions through their donor advised fund as family needs evolve over the years.  If Janet passes away before the twenty-year term expires, her children can step in and continue offering advice as to the direction of philanthropic support the trust will provide in the community.  If the trust pays out $25,000 annually and continues its historic performance for the duration of the trust’s term, there will be between $3 million and $7 million in the account that will pass nearly tax free to the heirs as if it used only $255,750 of Janet’s unified credit.  This is very efficient discounting and will provide the heirs with the resources for security and an opportunity to create their own remainder trusts in the future (see detailed flowchart).

flowchart1A CLAT can be easily described as a “deferred inheritance trust” and this offers the Bari family a degree of certainty as to when assets will be available to both charity and family members.  For the truly philanthropic, this plan offers donors a very useful means of passing assets to heirs in predetermined amounts, especially when insurance and wealth replacement trusts may not be economically viable options.