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Case Study: CLATs to Reduce Your Ordinary Income

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 as much as 100% 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 via advanced planning).

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!

charitable lead annuity trust

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 zero our your current tax bill — pay a very small amount (in the three or low four figures) every year, and defer your big tax bill until the final year of the trust, 20+ years from now.

Why does this work? In exchange for these promised 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 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.)

We know this is complicated, so let’s dive into a real-life example!

Quantifying The Savings

Take Alexei, who lives in the Bay Area and made partner at his law firm a couple of years ago. It’s a high-revenue firm, and, even as a junior equity partner, Alexei is bringing home a significant draw — $1 million per year. (Let’s assume for clarity’s sake that that’s Alexei’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, he’s paying a 46.6% effective tax rate. That’s a big hit.

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

If he does nothing, Alexei will owe the federal government about $359,000 in taxes, and California will get another $106,000, for a total tax bill of $465,000. That number is painful to stomach, and he would like to do some tax-deferral planning so he can keep investing and growing his assets instead of sending just about half of them out the door.

Let’s walk through how he can do that.

Setting the stage

  • Annual family income: $1,000,000
  • Expected Taxes: $$465,000
  • Gift to Trust: $500,000
  • Up-Front Deduction: $500,000
  • Expected Returns after 25 years (assuming a 9% annual growth rate over the term of the trust):
  • Baseline (that is, not using a trust): $1,797,000
  • CLAT: $2,314,000

We’ll show you how Alexei can earn an additional $517,000, or about 28% additional returns, using a CLAT.

clat case study

Immediate charitable deduction

The primary benefit Alexei will receive from putting his shares into a CLAT is an immediate tax deduction. He will get to deduct 100% of the current value of the assets he puts into the trust (assuming that amounts to less than 60% of his family’s adjusted gross income; if it’s more, he can spread the deduction out over multiple years). In this case, that’s a $500,000 deduction that translates into a cash savings of about $230,000 on his taxes. Critically, Alexei 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 Alexei’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. Alexei’s donations will total $912,000 over 25 years.

But if Alexei is going to have to donate more than $900,000 to charity in exchange for a $500,000 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, he gets to reinvest and grow his money for 25 years. Yes, he’ll end up donating more than the initial amount he put into the trust, but he gets to benefit from the magic of compounding in the meantime. He eliminates about $230,000 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 his annual donations, Alexei will receive all of the assets remaining in the trust — about $2.3 million on a pre-tax basis. Moreover, he 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 he can continue to let them grow in the market until he needs the liquidity.

How does Alexei plan to use his 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 Jeff’s bottom line?

After 25 years, Alexei expects to end up with about $2.2 million in total payouts. About $900,000 will go to the charity of his choice — that’s the bargain he struck when he chose a Charitable Lead Annuity Trust.

If, instead, Alexei had paid his taxes up front and reinvested the remainder — about $270,000 — in a regular, taxable investment account, he would have ended up with about $1.8 million.

In other words, even after making what can only be described as a *very* generous donation to charity, Alexei still pockets an extra $500,000, all because he used a Charitable Lead Annuity Trust.

Next Steps

Check out our next Case Study on a high-earning engineer that reduces ordinary income tax with a CLAT. Access our Charitable Lead Annuity Trust 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.