Ed Slott June 2023 Newsletter
Many people accumulate large sums of money in their IRA during their lifetime, much more than they spend in retirement. What is the best choice for beneficiary, to inherit the remainder at the IRA owner’s death? Spouse? Children?
Often, none of the above. Naming one or more charities to inherit an IRA can be a better decision. What’s more, the SECURE Act’s 10-year rule has made this tactic even more effective.
In brief, leaving a pre-tax IRA to qualified charities is ideal, as such charities will owe no income tax when selling the inherited holdings. Many taxpayers desire to make charitable bequests, and using a tax-deferred account for this purpose avoids the tax that was sheltered earlier. Who knows what tax rates will be in effect by the time human heirs owe tax on distributions from an inherited IRA, especially when most non-spouses will have to deplete the accounts within 10 years?
Before going into more details on this tax planning strategy, it is useful to consider philanthropy as having multiple tiers for people who are charitably inclined.
For younger and middle-aged donors, the basic way to help selected causes without tapping cash is to transfer appreciated securities.
Example 1: If Jill bought XYZ stock at $20 a share many years ago and those shares now trade at $60, after an extended bull market, they really are not worth $60 a share to Jill. Assuming an effective income tax rate of 30%, federal and state and net investment income surtax, and the resulting $12 tax hit (30% of an assumed $40 gain), the shares are worth only $48 apiece to Jill, post-sale.
Here, Jill intends to give $15,000 to charity this year, so she donates 250 shares. The tax-exempt charity can sell those shares and receive the full $15,000, to use as it deems best. Jill has parted with assets worth only $12,000 to her (after-tax, on a sale of 250 shares at $60), qualified for a $15,000 tax deduction, and retained $15,000 in cash that would have gone to charity with a simple donation.
Later Than Sooner
Once IRA owners reach age 70½, the top choice becomes using qualified charitable distributions (QCDs). QCDs of up to $100,000 per year per donor can go directly from an IRA to a qualified charity.
Starting at age 73 in 2023, required minimum distributions (RMDs) must be taken. QCDs satisfy RMDs but they do not count as taxable income. Holding down reported income in this manner may have many beneficial results, including lower income tax as well as possible future savings on Medicare premiums.
It is important to use QCDs before taking any other IRA distributions each calendar year. Any distributions that precede QCDs will be treated as taxable RMDs.
Splitting Under SECURE 2.0
For people who qualify for QCDs, the second tier is the ability to gift up to $50,000 to “split interest entities,” under the SECURE 2.0 Act. (A married couple with separate IRAs can put up to $100,000 into these arrangements.) The splitting in these plans involves some money going directly from an IRA to charity while also providing an income stream to the IRA owner. The eligible entities include charitable remainder annuity trusts, charitable remainder unitrusts, and charitable gift annuities.
Each type of arrangement is subject to technical rules, and full clarification of the SECURE 2.0 provisions may be revealed in the future. Nevertheless, given the fact that charitable gift annuities have no administration costs, this choice generally makes the most sense. Donors and their advisors always should check the financial viability of the charity, which usually bears the liability to continue to make payments under that arrangement. IRA owners may want to get quotes on future cash flow themselves or rely upon their advisors for that information.
For example, St. Jude Children’s Research Hospital now pays about 6% – 7.5% per year on its charitable gift annuities, depending on the donor’s age. That range seems to be common among charities now. The younger the donor, the longer the accepted life expectancy and the smaller the annual payout. Now the biggest question for charities such as St. Jude’s will be whether they can administratively handle this type of gift annuity, given the relevant provisions of SECURE 2.0.
The annuity income can be based solely on one individual or on two spouses and must be lifelong contracts. Such income will be fully taxable as ordinary income as it is received. Income from such a charitable gift annuity cannot be credited back to the charity but must be taken — and taxed — at least yearly.
Under SECURE 2.0, the dollar limit for one-time IRA contributions to a charitable gift annuity is now $50,000. If an IRA owner gives less, the balance cannot be made up in future years. Any amount given in this manner may have to be deducted from the current $100,000 maximum per year allowed as a QCD. Both the $100,000 QCD annual limit and the one-time $50,000 split interest limit will be adjusted for inflation, as of 2024. Hence, after a charitable gift annuity is funded through an IRA, an individual will be able to give up to the maximum amount allowed per year as a QCD.
Having the Last Word
The plans mentioned include some savvy ideas for lifetime philanthropy. In addition, charitably-minded taxpayers often wish to make charitable bequests, which may be substantial. Some people may be reluctant to donate heavily while alive but wish to provide ample amounts to a favored charity at death. In any case, these post-death charitable gifts usually should be made through a pre-tax IRA, which tops all other assets for such donations.
Before going into detail, some procedural tests should be passed. First, determine whether the IRA custodian will accept a non-person as an IRA beneficiary. Many custodians have the ability to allow for the naming of charitable beneficiaries as partial beneficiaries, perhaps receiving a small percentage of the account, as well as for naming a charity as the sole beneficiary. If a satisfactory agreement can’t be reached, an IRA owner desiring to leave the account to charity can transfer the funds to a custodian that will permit this choice.
Generally, it is better to have separate IRAs holding assets meant for charity, for administrative ease. The process becomes more complex if the charity or charities share an IRA with other types of beneficiaries. For an IRA with a mix of beneficiaries to have favorably treated designated beneficiaries, all non-person beneficiaries such as charities must take a full distribution of their inheritance by September 30 of the year after death or disclaim their inherited assets by that date. If that deadline is missed, human co-beneficiaries may have to take their full share of the account — and pay income tax — within 5 years.
More questions may face married couples. In what order would they prefer the charity receive the funds? If the spouse is the primary beneficiary to receive IRA funds, does he or she understand the importance of filing a disclaimer, which could benefit the charity immediately at the first spouse’s death? Again, it’s vital to determine whether the custodian will recognize a qualified disclaimer for the surviving spouse to advance the gift to charity earlier, and to decide whether a change in custodians may be necessary. Also, both spouses should be familiar with the mechanics of making a full or partial disclaimer.
From Pre-Tax to No-Tax
As is the case with a lifetime donation of appreciated securities, as described, a qualified charity named as a traditional IRA beneficiary can sell the assets involved and owe no tax on the amount received. Leaving, say, $100,000 to a specific charity via an IRA would provide the charity with $100,000 to use. If that same $100,000 of IRA money were left to a non-spouse, all the money would have to be withdrawn within 10 years, in most cases. Some human beneficiaries would owe annual RMDs, with stiff penalties for non-compliance. Moreover, distributions of appreciated assets from IRAs are fully taxed as ordinary income, losing the tax advantages of selling long-term capital gains.
As an additional tax advantage of leaving IRA money to charity, the amounts involved can be taken as an estate tax charitable deduction. Estate taxes may not be a major concern now, but IRAs may pass to beneficiaries many years in the future. Just as ordinary income tax rates on IRA distributions may be higher then, estate tax exemptions might be lower, exposing more heirs to estate tax at higher rates. Doesn’t it make sense to shelter loved ones from future estate tax as well as future income tax?
Caution: Money held in traditional IRAs meant for charitable bequests should not be converted to Roth IRAs. Such conversions generate taxes that can be avoided if the dollars involved will pass to a charitable beneficiary.
IRA owners leaving their retirement accounts to charity may want to offset the loss of money for spouses, children, and others. Instead of receiving an IRA, heirs might receive appreciated assets, such as securities, real estate, or private business interests. Under current law, such inherited assets receive a basis step-up to current value, resulting in lower or no tax on a subsequent sale.
Another method of replacing lost IRA money is to purchase life insurance on the IRA owner, payable to the passed-over potential IRA beneficiaries. Those loved ones could be the policy beneficiaries, receiving the death benefit, tax-free. Heirs probably would prefer to inherit, say, a $250,000 life insurance policy payout, free of income tax, than a $250,000 IRA, burdened with whatever tax will apply in the future. Indeed, this strategy is so appealing that my wife Jill and I are using it personally. One hundred percent of our IRA and 401(k) accounts will go to charity on our deaths. Our children know this will happen.
Telling the children that we intended to gift all of our tax-qualified accounts to charity at our deaths was very difficult. I was truly surprised how tough that was for me. However, once I explained our thinking to them, pointing out that they would receive other assets, including tax-free life insurance proceeds, they seemed fine. Properly presented, tax-free always beats tax-deferred!
Advisor Action Plan
σ For clients who are charitably-inclined, find out whether they wish to give to charity while alive, through their IRA at death, or both.
σ Once clients reach age 701/2, suggest using QCDs for philanthropy, including the split interest opportunities in SECURE 2.0.
σ When the focus turns to estate planning, explain the tax advantages of leaving tax-deferred IRAs and other retirement plans to charity.
σ Ease client concerns about depriving heirs of IRA money by telling them about tax-advantaged assets they could provide instead, such as appreciated securities and life insurance proceeds.
Investment Advice offered through Capital Asset Advisory Services, LLC. dba CG Advisory Services, a registered investment advisor.