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Yield-Focused Investment With A Charitable Remainder Trust

With the Active Yield strategy, you could earn an additional 60% return on your money while invested in assets that generate yield and other short-term income, including debt, real-estate, cryptocurrency, and stocks paying non-qualified dividends. Accordingly, this strategy can be a fit for generalist investors looking to optimize the use of their CRT, but it is especially valuable for those who are already earning (or plan to earn) significant yield from their investments and want to achieve greater tax efficiency.

Overview

In our last post, we spent some time covering two common investment strategies that work well in conjunction with a Charitable Remainder Trust: the Active Yield strategy and the Passive Growth strategy. Both strategies can be powerful given the tax deferral inherent in CRTs, but which one is right for you? It depends, of course, on your preferences and financial situation.

Today, we’ll cover the Active Yield strategy, which focuses on interest-producing assets. With this strategy, you could earn an additional 60% return on your money while invested in assets that generate yield and other short-term income, including debt, real-estate, cryptocurrency, and stocks paying non-qualified dividends.

In particular, we’ll look at two questions: (1) If you have chosen to use a CRT, should you consider Active Yield as part of your investment strategy? and (2) If you are already planning to invest in high-yield assets, does this strategy make sense as a way to reduce your taxes?

What are high-yield assets?

Typically, this is any asset that pays some sort of interest (also called a “coupon”) or other regular cash payments. These include:

  • Dividend-paying stocks (and specifically “non-qualified” dividends, which are commonly received from investments in REITs, MLPs, and other foreign public entities)
  • Crypto lending/yield farming (but not staking — more on that distinction in a future post)
  • Rental properties
  • Other financial instruments, including bonds, private company debt, and certificates of deposit

Why are high-yield assets a good fit for a Charitable Remainder Trust?

The typical diversified-portfolio investment approach — the one most regular people follow, for what it’s worth — is all about ensuring steady growth when looked at over the very long term. High-yield investing, by contrast, is about creating income today. That different focus opens some doors, especially when combined with a tax-deferred trust.

Guaranteed return. Unlike assets that depend mostly or entirely on appreciation — ETFs, mutual funds, and the underlying stocks, for example — high-yield assets typically guarantee some cash return each year. That return could vary, to be sure, especially in a volatile space like crypto, but yielding assets by definition are expected to throw off some cash consistently.

With crypto lending, for example, you agree to lend out your tokens in exchange for interest payments, which can vary over the course of the year but will often be quite high. Rental real estate is similar, in a sense, if also more predictable: You are promising to allow a renter to use the property in exchange for rent payments, which is steady income for you.

Tax-deferred income. Perhaps most powerful is the potential to realize yield tax free inside a Charitable Remainder Trust. Income from high-yield investments is typically taxed at the highest rates — up to 55% in high-tax states like California and New York — but you can reduce the portion of your income that is taxed with a trust. In particular, any yield above your trust’s annual distribution rate will stay inside the trust and will grow tax free until you withdraw it sometime in the future.

An Example

Those tax savings can be massive, but the logic is not necessarily intuitive, so let’s take a look at an example.

Take Krish, a 31-year old living in California, who recently got married and is aiming to achieve financial independence and retire early. Krish has made some significant returns in the crypto market and is bullish on the industry, but he wants to build some less speculative investments into his overall strategy.

To carry out that  approach, Krish turns to yield farming to lock in a consistent return for at least the next few years. He decides that the best trust for him — like a large majority of our users — is a Lifetime NIMCRUT, because it gives him the longest runway to grow assets tax free while at the same time allowing him the option to defer distributions if he wants.

Other Assumptions

Cost basis/expected value at sale: Krish has a cost basis of $10,000 in tokens he expects to sell for $2 million when he sets up his trust.

Investment strategy: Going forward — after selling at least some of his assets up front — Krish will invest in liquid crypto (stablecoins) with an annual yield rate of 9.0%. (Some exchanges offer even greater returns, but we’ll be relatively conservative here.)

Annual trust payout rate: 5.5%

Ordinary income tax rate: 40%

How does this strategy pan out?

We’ll assume that Krish sells his initial portfolio of tokens and then reinvests the proceeds in yield-generating stablecoins. If he does that inside of a charitable trust (with the inherent tax deferral), the overall after-tax returns are substantially higher than if he did it in his own account and paid the taxes. With a Charitable Remainder Trust, Krish could take home $6.72 million (after taxes) over the course of his life, compared to just $4.2 million if he just pays his taxes every year. That’s an additional $2.52 million, or a 60.5% increase. Plus, he would get to donate an additional $6.7 million to charity, benefitting many causes that he’s passionate about.

Why are the returns on this strategy so huge?

There are many moving parts here, but the outsized returns from this approach come mostly from one place: Tax deferral.

Immediate tax deferral. First, there’s the up-front tax savings on the initial sale of appreciated assets. Krish is selling crypto worth $2 million today. If he chooses not to use a trust, he’ll pay upwards of $700,000 in capital gains taxes immediately, allowing him to reinvest $1.3 million. If, instead, he puts his assets into a CRT before selling, he’d pay zero taxes when he sells, which means he’ll get to reinvest the full $2 million. Everyone reading this is going to have a different set of prior knowledge, but it’s not hard to see how re-investing $2 million (and capturing the resulting yield) is going to be significantly better than doing the same with only $1.3 million.

Additional tax savings on each year’s yield. This is where the synergy between charitable trusts and yield farming really shines. Each year, Krish is going to cash out some yield as a result of the rules of his trust — we stipulated 5.5%. He’ll pay taxes on that amount just like he would have if he hadn’t used a trust. But any yield about that 5.5% is going to stay inside the trust, and it won’t be taxed until Krish cashes it out. So just as with the initial capital gains, Krish gets to grow his yield every year and reinvest it tax free. (Plus, this growth compounds, since, each year, the principal on which he’s earning yield will get even bigger.)

Other tax savings. In addition to those massive tax savings, there are a few other benefits of the trust/yield approach. There’s the standard up-front 10% tax deduction on any assets put into the trust — that’s a $200,000 deduction in year 1 for Krish on his initial investment of $2 million. And there’s also tax smoothing — we are spreading Krish’s income out over 45 years instead of having him take a massive amount of capital gains income (and pay the required taxes) in the first year. As a result, his average tax rate will be lower.

The Numbers

 Year Trust Principal   Balance Yield Payout Taxes After Tax   Proceeds Taxes Saved   (Undistributed   Interest)
 1 $2,000,000 $180,000 $119,856 $47,973 $71,914 $24,057
 2 $2,053,194 $184,787 $123,044 $49,218 $73,827 $24,697
 3 $2,107,842 $189,706 $126,319 $50,528 $75,792 $25,355
 4 $2,163,985 $194,759 $129,684 $51,873 $77,810 $26,030
 5 $2,221,663 $199,950 $133,140 $53,256 $79,884 $26,724
 15 $2,892,717 $260,345 $173,355 $69,342 $104,013 $34,796
 30 $4,308,366 $387,753 $258,193 $103,277 $154,916 $51,824
 45 $6,430,201 $578,718 $385,350 $154,140 $231,210 $77,347
After tax proceeds

The Numbers

 Year Any Taxable   Account (Your   Personal Account)   Principal Balance Yield Payout Taxes After Tax   Proceeds Taxes Saved   (Undistributed   Interest)
 1 $2,000,000 $180,000 $180,000 $768,500 $108,000 N/A
 2 $1,300,000 $117,000 $117,000 $46,800 $70,200 N/A
 3 $1,300,000 $117,000 $117,000 $46,800 $70,200 N/A
 4 $1,300,000 $117,000 $117,000 $46,800 $70,200 N/A
 5 $1,300,000 $117,000 $117,000 $46,800 $70,200 N/A
 15 $1,300,000 $117,000 $117,000 $46,800 $70,200 N/A
 30 $1,300,000 $117,000 $117,000 $46,800 $70,200 N/A
 45 $1,300,000 $117,000 $117,000 $46,800 $70,200 N/A
Taxable account

‍With that summary in mind, let’s dig into the mechanics of this example to see how each feature plays out in detail.

Principal Balance

  • In the first year, both scenarios — trust and no trust — start off with the same balance. The trust keeps 100% after Krish sells his assets because of its tax-exempt status, while the taxable account isn’t required to pay any taxes until the end of the year.
  • Year 2 and onward is where the real difference appears. The trust’s principal is growing each year because of the undistributed proceeds that remain in the trust to grow tax free. The taxable account, meanwhile, stays flat because each year because it distributes 100% of the yield proceeds and there is no capital appreciation.
  • By year 30, the trust has almost 3 times the assets of the simple taxable brokerage account.

Yield

  • In the first year, the yield is the exact same in each scenario because each captures 9% yield on $2m of principal (because the taxable account doesn’t pay its taxes on the $2m sale until the end of the year).
  • From year 2 onward, you can see the real impact of the trust, with the annual yield consistently growing as the trust’s value gets bigger, whereas the taxable account stays flat over the same period because we are taking all of the yield out and paying taxes immediately.
  • By year 30, the assets are yielding more than 3 times the amount of annual growth due to the consistent increase in principal each year.

Payout

  • The first year is really the only time the taxable account does better than the trust. Because there are no limitations on withdrawals from a personal account, you get access to the full $180,000 of yield, whereas the trust can only distribute $119,856 because of the IRS-defined payout rate. That’s a ~$60,000 difference before tax.
  • Starting in year 2, the tables turn, and the payout will be higher in the trust scenario every year thereafter. This is the main value of using a Charitable Remainder Trust: having access to more assets to reinvest and capturing the huge compound growth.
  • The impact of this difference is considerable in later years. You can see the results in the tables, but, to take one example, by year 30 the trust is distributing well over double what the taxable account would be throwing off annually.

Taxes

  • The two scenarios differ significantly with respect to taxes in year 1. This discrepancy is driven by the tax-exempt status of the trust, as compared to the taxable nature of the typical account; with the taxable account, the entire gain is subject to tax on sale.
  • The taxes paid by the trust are marginally higher in the early years, driven by the larger distributions, but you can see over time that the trust will inevitably pay more taxes (in absolute dollars) simply because you’ve received significantly more distributions.

After Tax Proceeds

Even despite those higher absolute taxes, the trust’s after-tax proceeds will be significantly higher. Indeed, in every year except for the first year, the trust will throw off more after-tax dollars directly to you (to use however you want).

The Returns

To recap: The overall after-tax returns are substantially higher using the charitable trust than they would have been if we pursued the same yield strategy in a regular account and paid the taxes every year. With a Charitable Remainder Trust, Krish could take home $6.72 million (after taxes) over the course of his life, compared to just $4.2 million if he just pays his taxes every year. That’s an additional $2.52 million, or a 60.5% increase. Plus, he would get to donate an additional $6.7 million to charity.

Next Steps

No investment strategy — indeed, no tax-planning approach — is a perfect fit for everyone. The strategy you choose at the outset may not even be the best one for you down the road. Fortunately, charitable trusts are flexible, and you can pursue different investment strategies over the years as your priorities change. No matter your chosen strategy, though, one thing is clear: An Active Yield investment approach can generate significant returns within a Charitable Remainder Trust.

If you are planning to use a CRUT to reduce the taxes on your sale of appreciated assets, the CRUT/stablecoin approach might be a good fit, try out our tax planning calcutor to evaluate the results given your situation. To know more, follow our series with our article on how to pass on the assets in a lifetime CRUT, or meet with our team!

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.