Charitable Remainder Annuity Trusts (CRAT) Part 3

How Your Annuity Payments Are Taxed:

Annuity payments paid to the beneficiary retain the same character they had in the trust. For example, each payment will be treated as ordinary income, capital gain, tax-exempt income, or a tax-free return of principal. The annuity trustee will advise you on how to report the annuity payments on your taxes.

Favorable Tax Treatment For Your Payments:

Depending on how the annuity is invested, payments to the beneficiary may be considered capital gain or a tax-free return of principal. This can be achieved by opting for a growth instead of an income-centered investment strategy. Principal or capital gains will be distributed if the trust income is less than the stated percentage to be distributed to the beneficiary. The following examples illustrate the tax consequences of growth and investment strategies.

Example 1:

Bob has a 7 percent annuity trust funded with $100,000 in cash. The annuity earns $7,000 in dividends for the year, and the full amount is paid to Bob. The payments are taxed as ordinary income.

Example 2:

The trustee follows a growth instead of an investment policy. Bob’s trust appreciates to $107,000 but does not earn income. In order to make the required $7,000 payment to Bob, the trustee sells $7,000 in stocks. If the stocks had a cost basis of $5,000, Bob receives a $5,000 return of principal and another $2,000 in capital gains.

The following example illustrates how a trustee would advise a trust beneficiary to report trust income on their income tax return.

Year One:

The beneficiary is to receive $7,000 on their 7 percent annuity funded with $100,000. During the first year, the trust earns $2,000 in dividends, receives $2,000 in interest from tax-free municipal bonds, and sells stocks with a $2,000 cost basis for $4,000. The $7,000 annuity payment would be taxed as

  • $2,000 tax-free interest income,
  • $2,000 ordinary income,
  • $2,000 capital gain income, and
  • $1,000 non-taxable return of principal.

Year Two:

The trust earns $8,000 in dividends and receives $1,000 in tax-exempt interest. The trustee also sells $12,000 in stocks having a cost basis of $9,000. The entire $7,000 annuity payment is considered ordinary income.

Year Three:

The trust receives $750 in tax-free interest and $1,000 in dividends. The $7,000 payment to the beneficiary would be taxed as

  • $3,000 capital gain income undistributed in the second year,
  • $2,000 of ordinary income, comprised of $1,000 in dividends undistributed in year two and $1,000 in dividends from year three,
  • $1,750 in tax-free interest, comprised of $750 from year three and $1,000 undistributed during year two, and
  • $250 as a tax-free return of principal.