We’ve spent time covering two common investment strategies for Charitable Remainder Trust users: Yield and Growth Strategies. Both strategies are inherently powerful when used within CRUTs, but which is the right fit for you? You hear this a lot from us: It depends on your personal preferences and financial goals. Fortunately, though, you can alter your approach over time as your needs change.
The Growth strategy, just like its name, is about selecting a mix of assets with a focus on long-term capital appreciation. With this strategy, you could earn an additional 58% return on your money by avoiding upfront distributions so you can further defer taxes and allow more of your assets to grow faster on a pre-tax basis.
We’ll look at two primary questions: (1) If you have chosen to use a CRUT, what are the advantages and trade-offs of a Growth focused investment strategy? And (2) How can investing in growth assets for the long term potentially impact your access to liquidity?
What assets offer long-term capital appreciation?
There are plenty of assets that offer the opportunity for capital appreciation, whether it be short term or long term. Common assets include:
- Public equities (dividend or non-dividend paying stocks)
- Private stocks
- Real estate
- Collectibles (art, cars, trading cards, etc.)
You may see some overlap here with assets often found in the Yield strategy as well. This is because there are many asset classes that offer yield focused investments in conjunction with growth focused investments. Examples of assets that fit both categories as you’d imagine include dividend paying stocks, rental real-estate, crypto like BTC/ETH that can receive yield, etc.
Why are long-term capital appreciating assets a good fit for a Charitable Remainder Trust?
A diversified-portfolio investment approach is all about ensuring asset growth over the long term. That strategy is particularly powerful when paired with a NIMCRUT (Net Income with Make-up Charitable Remainder Trust) because it can allow for additional tax-free compounding without the drag of forced trust distributions, resulting in earlier-than-necessary tax obligations.
Additional growth due to no forced distributions. The most compelling benefit of a Charitable Remainder Trust is the ability to defer your capital gains taxes so you have more money working for you in the market. Investing primarily in appreciating assets inside a NIMCRUT can supercharge that opportunity.
Why? If you choose a NIMCRUT as the tool to maximize your returns — which the vast majority of our users do — you will be required to take a distribution each year equal to the lower of (1) the trust’s net realized income or (2) the trust’s defined payout rate. If you’re invested in growth assets only and avoid yield producing assets, you can reduce trust’s annual realized income, allowing you to defer your distributions for future years and keep more assets growing on a pre-tax basis inside the trust. Those assets, in turn, can continue to compound tax free for much longer, which means a larger total payout from the trust over the long term (if you want to see for yourself check out our calculator to compare the returns for yourself).
When comparing the growth strategy to the yield strategy, a yielding strategy given that it’s always generating some sort of income would allow you take a distribution every year that yields are positive. Thankfully, just like with your personal taxable account, you can shift investment strategies anytime you’d like within the trust. Assume your stock portfolio declines 30% through the first 6 months of a year and the trust’s math says that a distribution is out of the question. You could simply sell those positions and invest in a yielding security until you feel markets are prepared to rebound, and then simply shift your portfolio from yield securities to growth assets again.
Take Daiyu, a 43-year old living in New York. She has spent a considerable part of her career working at successful start-ups, but now she’s prepared to sell some of those positions and reinvest mostly in stable public equities, while allocating some to her friends high growth startups.
Daiyu has done exceptionally well and is most interested in deferring income for quite a few years, until she’s in need of proceeds for major life expenses. She decides that the best trust for her — like a majority of our users — is a Lifetime NIMCRUT, because it gives her the most flexibility to grow assets while exercising some control over when to realize income.
Cost basis/expected value at sale: Daiyu has a cost basis of $1000 (because she early exercised) and expects to sell those shares for $1.5 million when she sets up her trust.
Investment strategy: Once the shares are sold, Daiyu will mostly invest in a mix of public equities (non-dividend paying) and select startup opportunities along the way.
Annual trust payout rate: 7.65%
Capital gains tax rate: 35%
Annual capital gains appreciation: 12% (a reasonable estimate given the historical return of high-growth consumer/technology stocks and venture capital investments)
How does this strategy pan out and what are the returns?
If Daiyu does everything listed above inside of a charitable trust (with the tax deferral benefits), the overall after-tax returns are substantially higher than if she did it with her own account and paid the taxes up front. With a Net Income Charitable Remainder Trust, Daiyu could take home $18.1 million (after taxes) over the course of her life, compared to just $11.4 million if she paid her taxes after the initial sale. That’s an additional $6.6 million, or a 58% increase. Plus, she would get to donate an additional $12 million to the charitable causes she’s passionate about!
The numbers are clear: A Charitable Remainder Trust paired with a growth strategy significantly outperforms not using a trust at all. But say you’ve already decided to use a trust to reduce your taxes. Which investment strategy should you use?
How does the growth strategy stack up versus the yield strategy?
Using the growth strategy and a charitable trust, Daiyu could take home $18.1 million after taxes over the long run. If instead she had invested those assets into high-yield assets over the same period, at the same annual return of 12%, she would have taken home only $5.03 million after tax. So the growth strategy wins by a country mile in terms of absolute dollars. The question, however, is, as always, risk-adjusted return and potential volatility. Growth assets aren’t guaranteed always to go up and to the right at 12% annually. Yielding assets, by contrast, might offer a more consistent annual return. Accordingly, a yield strategy might offer greater access to liquidity in years when markets are down, while the growth strategy might offer the greatest absolute returns over the long term.
Here is a brief comparison of the different strategies, with the Taxable Account scenario as the baseline.
|Investment Strategy||Account Type||Total After Tax Proceeds||Extra Payout||Extra Payout %||Charitable Donation|
Why are the returns of the growth strategy so huge?
Immediate tax deferral. Because CRUTs are tax exempt they offer an up-front tax savings on the initial sale of appreciated assets. Daiyu is selling start-up equity worth $1.5 million today. If she chooses not to use a trust, she’ll pay upwards of $500,000 in capital gains taxes immediately, allowing her to reinvest $1 million. If, instead, she puts her assets into a charitable remainder trust, she’d pay zero taxes when she sells, which means she’ll get to reinvest the full $1.5 million into her chosen assets.
Every reader will have a different set of experiences and prior knowledge, but it’s not hard to see how investing an extra $500,000 for many years can be incredibly impactful: That additional investment, growing at historical rates over a long enough period, could add almost 58% more to your take-home dollars.
Deferring payouts by controlling the realization of income. Investing the additional dollars is certainly important, but it’s not the only thing contributing to the additional return on investment over Daiyu’s life. The ability to keep those annual gains invested in the trust and growing tax free for an extended period of time maximizes the power of a charitable remainder trust.
The mechanics are relatively simple: She would choose to realize income only when she wants to take distributions or rebalance her portfolio, but otherwise she would hold assets for the long term. This will help achieve the highest absolute returns. (Note that this is all based on the assets growing in most years for the life of the trust. In scenarios where assets decline, you can employ strategies like tax loss harvesting to further optimize the effectiveness of the trust).
Other tax savings. In addition to those massive gains, there are other benefits of the passive growth approach. There’s the standard up-front 10% tax deduction on any assets put into the trust — that’s a $150,000 deduction in the year that Daiyu contributes her $1.5 million of assets to the trust. And there’s also tax smoothing — we are spreading out Daiyu’s distributions over an expected 36 years, which reduces her average effective tax rate in each year as compared to a large capital gain in one year.
What are the potential tradeoffs of this strategy?
Growth assets are great when growing, but as many of you reading this know all too well, growth assets don’t always go up. If you keep investments in your personal taxable account you always have access to the principal, assuming you’re willing to accept some level of realized loss in a down market. When it comes to using a charitable remainder trust, specifically a NIMCRUT where the trust looks at realized gains as income to determine distributions, this could prove troublesome in years where assets are consistently declining. In a down market, the growth strategy may ultimately limit your ability to gain liquidity from the trust.
In terms of liquidity, its easy to see why this is one of the primary trade-offs between strategies and charitable trusts in general. The growth strategy starts off slow and really builds overtime to offer the most liquidity by the end of your trust. But in earlier years, you might think “what if I want access to more of my funds to pay expenses or buy some toys”, this is where a yield strategy offers more up front liquidity but significantly less in the later years.
Reference the table below to see the expected pre-tax liquidity at milestone years for the different scenarios:
|Investment Strategy||Account Type||5 Year Liquidity||10 Year Liquidity||20 Year Liquidity||30 Year Liquidity|
The overall after-tax returns are substantially higher using the charitable trust than they would have been if Daiyu pursued the same growth strategy in a regular account and paid her taxes right away. With a Charitable Remainder Trust, she could take home $18.1 million (after taxes) over the course of her life, compared to $11.5 million if she just pays her taxes up front. That’s an additional $6.6 million, or a 58% increase. Plus, she would get to donate an additional $12 million to charity.
When comparing this approach to a yielding approach the question is simple: “Do I care more about maximizing the short term liquidity I can take out of the trust or am I more interested in maximizing long-term proceeds?” Get in touch so we can help you figure out the right choice for you!
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.