Case Study: Reducing Ordinary Income Tax With A CLAT

You’ve made it: Your law firm elected you partner, you reached managing director at your investment bank, or maybe you’re leading a high-performing team at a blue-chip tech company. No matter how you got there, you’ve reached the point where your annual income is outpacing your everyday needs, and even your usual wants. So what now?

For most people in this situation, financial planning becomes a multi-layered pursuit — you max out your 401(k), of course, you give to your kids’ 529 account, you slip in a mega-backdoor Roth — but you’ve still got significant excess income. That’s not a problem in and of itself, but there is an undesirable side effect: Earlier in your career, those basic planning tools helped you offset a significant portion of your taxable income, but that’s no longer the case. Today, it looks like you’re going to be stuck with a massive tax bill.

But it doesn’t have to be that way. In this article, we’ll explain how you can use a Charitable Lead Annuity Trust like an uncapped 401(k) or IRA, to shield all of your ordinary income from federal and state taxes.

How It Works

At a basic level, a CLAT is simple:

1. You gift some of your income to the trust and get a charitable deduction up to the entire value you donated.
2. You reinvest the cash in other assets during the term of the trust.
3. Every year, the trust donates a predetermined amount to a recognized charity — either an established nonprofit like the American Cancer Society, or your own Donor Advised Fund. You are liable for the taxes on the income generated inside the trust (though we work with you to minimize this tax exposure).
4. At the end of the trust’s term (a predetermined number of years), you or your beneficiary receive the remaining trust assets.
5. Celebrate — You successfully deferred your taxes and were able to reinvest what would be taxes to keep those assets compounding and working for you!

Why It Works?

By putting your assets or cash into a CLAT and setting it up to pay out to charity very slowly, you can back-load your tax obligation — enabling you to reduce your current tax bill — and defer your big tax bill far out into the future.

Why does this work? In exchange for these promised future donations, the government allows you to take a large up-front deduction — as much as 100% of the amount you put into the trust. Although the math is complicated, the IRS is essentially calculating the value, in today’s dollars, of all of the money you pledge to give to charity over the term of the trust; by back-loading those payments, you can reinvest the money and earn much more than what the IRS is requiring you to donate. For those interested in the math: 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 when you pay taxes in the future you pay a lower tax rate as long-term capital gains.

We know this is complicated, so let’s look at a real-life example.

An Example: Quantifying The Savings

Take Jenn, who lives in New York City and rose to Managing Director at her bank over the past few years. It’s a high-revenue firm, and, even as a relatively junior manager, Jenn is bringing home a significant draw — $2 million per year. (Let’s assume for clarity’s sake that that’s Jenn’s family’s entire taxable income.) All of that income, of course, is taxed at the highest federal and state rates, and, as a result, she’s paying a 45.6% effective tax rate. That’s a big hit.

There’s good news, though: Jenn can use a CLAT to eliminate much of her ordinary income this year, reinvest that money now, and pay most of her taxes at a lower tax rate far in the future.

If she does nothing, Jenn will owe the federal government about $690,000 in taxes, and New York (city and state) will get another $222,000, for a total tax bill of about $912,000. That number is painful to stomach, and she would like to do some tax-deferral planning so she can keep investing and growing her assets instead of sending just about half of them out the door.

Let’s walk through how she can do that.

Setting the stage

Gift to Trust: $1,000,000

Up-Front Deduction: $1,000,000

Expected Returns after 25 years (assuming a 9% annual growth rate over the term of the trust):

Baseline (that is, not using a trust): $3,665,000

CLAT: $4,552,000

We’ll show you how Jenn can earn an additional $1.2 million, or about 24% additional returns, using a CLAT.

Immediate charitable deduction

The primary benefit Jenn will receive from putting her shares into a CLAT is an immediate tax deduction. She will get to deduct 100% of the current value of the assets she puts into the trust (assuming that amounts to less than 60% of her family’s adjusted gross income; if it’s more, she can spread the deduction out over multiple years). In this case, that’s a $1,000,000 deduction that translates into a cash savings of about $450,000 on her taxes. Critically, Jenn gets to reinvest that money instead of paying it to the government.

What happens while the trust is operating?

Every year, the trust will make a small donation to the charity of Jenn’s choice. (Recall that these promised donations are why the government allows you to take a large up-front deduction; although the math is complicated, the IRS is essentially calculating the value, in today’s dollars, of all of the money you pledge to give to charity over the term of the trust.)

Following the IRS’s prescribed procedure, that small donation to charity will start in the low four figures and grow 20% per year. Jenn’s donations will total $1,824,000 over 25 years.

But if Jenn is going to have to donate more than $1.8 million to charity in exchange for a $1,000,000 deduction, where’s the benefit of this strategy? The key is that, by taking the deduction on day 1 and deferring the majority of the donation, she gets to reinvest and grow her money for 25 years. Yes, she’ll end up donating more than the initial amount she put into the trust, but she gets to benefit from the magic of compounding in the meantime. She eliminates about $$450,000 in taxes at the beginning, reinvests that money for 25 years, and gets to reap most of the gains in the end.

Indeed, in the final year, after making her annual donations, Jenn will receive all of the assets remaining in the trust — about $4.7 million on a pre-tax basis. Moreover, she 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 she can continue to let them grow in the market until she needs the liquidity.

How does Jenn plan to use her money?

One of the first questions our customers ask us about CLATs is the following: “These gains are great, but my money will be locked up for the entire term of the trust. So what’s the use case?” It’s true that, unlike a Charitable Remainder Trust, a Charitable Lead Trust does hold your money for the trust’s entire term. For that reason, most people think of a 15-, 20-, or 30-year CLAT like a retirement savings account or IRA, with the assumption that they’ll use the proceeds in retirement.

Total Returns

What would all of these tax savings, investment gains, and donations mean for Jenn’s bottom line?

After 25 years, Jenn expects to end up with about $4.7 million in distributions to herself. An additional $1.8 million will go to the charity of her choice — that’s the bargain she struck when she chose a Charitable Lead Annuity Trust.

If, instead, Jenn had paid her taxes up front and reinvested the remainder — about $550,000 — in a regular, taxable investment account, she would have ended up with about $3.5 million.

In other words, even after making what can only be described as a very generous donation to charity, Jenn still pockets an extra $1.2 million, all because she used a Charitable Lead Annuity Trust.

Next Steps

Already sold your crypto? Then it’s time to defer your taxes with a CLAT. Try our calculator to evaluate your potential return on investmeent, or schedule a call to meet our team and share your experience!

About Valur

We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy.