Welcome to the world of Charitable Planning
If you have money, a charity will tell you at the end of the year that this is an excellent time to donate since you will get a tax deduction. That is true, of course. It’s also somewhat inefficient in many cases unless it is a small donation (small means different things to different people).
In general, the value of a tax deduction is the highest marginal tax rate times whatever you are donating. So if you have a 30% tax rate and contribute $100, you saved $30 in taxes. Not bad.
However, charitable planning is significantly more powerful. Charitable planning results in tax savings and benefits for charity, but it can also be a powerful driver of increased wealth over time. I use charitable planning in many situations; the most obvious is when people have a capital asset to sell. Charitable planning can give tax benefits that go well beyond the deduction (that is outside the scope of my post today though).
Here I discuss a scenario where there is no capital asset, just cash. Let me give you two easy-to-understand examples.
Example 1: Abbas
Abbas is a salesman. He normally makes a comfortable living, but he does not have enough for his family’s future. 2021 was a banner year for him. He earned $1,000,000 more than he usually earns. He does not expect to earn anything quite like this for a while. He is looking at a massive tax bill; he figures the marginal tax rate in his high-tax state is 50.3% (both federal and state). He donates $300,000 at the end of the year. He gets a tax-deduction for $300,000.
Example 2: Haroon
Haroon is a computer engineer. Like Abbas, he makes a comfortable living but would like to save more for his family’s future. He had an unusual year where a company he worked for went public. He had a wonderful “liquidity event” (as they say in the Silicon Valley), but it also happened to be $1,000,000 more in income tax liability than he would otherwise get. He donates only $15,000 by the end of the year. He gets a tax-deduction for $285,000. He invests the rest but eventually donates $300,000 over 20 years while the investments grow to be worth several times this in 20 years.
Wait, what just happened?
Grantor Charitable Lead Annuity Trust (GCLAT)
Charitable trusts come in a variety of flavors. I am only going to discuss this specific one since it applies to many people who have those once in a while years, where people do well but are concerned about income taxes, but not estate taxes (married couples need $23.4 million in 2021 before they need to worry about that). They are also charitable. However, they are not so charitable that they will give away hundreds of thousands of dollars for a tax benefit that they can get for a more spread-out donation.
How a GCLAT Works
Haroon creates a grantor trust, which means he is the taxpayer- this is critical because he wants the tax deduction from his income taxes. Most charitable lead trusts are non-grantor trusts designed to save on gift and estate taxes.
Haroon, in his trust, decides to donate 5% of the trust corpus every year for 20 years. These numbers can be less or more, depending on his goals. If he earns income on it, he pays taxes. Because he already got his charitable deduction in year one, he won’t get a charitable deductions again for the same donation. His year one charitable deduction is based on calculating the “present value” of the gift he did not give yet.
A GCLAT is known as a “split-interest trust”- a present and a future interest. We calculate the deduction through what is known as the “7520 rate” (after the tax code section). In October, the rate was only 1%. In November, it is 1.4, which is still low (though it has been as low as .6% this year). The lower the rate, the more the potential charitable deduction. Some Muslims get a little concerned when they see an interest rate. There is no loan; we use the “interest rate” to calculate the value of the gift.
The trust can last five years, or, as I noted in the example, 20 years. It can, in the right situation, be a great way to give a lot in charity, save a bundle in taxes in the year it’s needed most, and build long-term wealth. It’s not for everyone. But for the right person, it’s worth considering.