15. Donating Retirement Assets, Part 2 of 2

15. Donating Retirement Assets, Part 2 of 2

Article posted in General on 11 August 2016| 2 comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 18 August 2016
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VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

15. Donating Retirement Assets, Part 2 of 2

Links to previous sections of book are found at the end of each section.

Giving from retirement accounts during life often may have negative tax consequences, but in some cases – such as a qualified charitable distribution – may have distinct tax advantages.  Charitable giving from traditional retirement accounts at death, in contrast, is almost always more beneficial than giving other types of assets to charity at death.
Traditional retirement account assets are “tax heavy” for heirs.  Not only are these assets subject to gift and estate taxation, but they are also subject to income taxation.  The money in these traditional accounts has never had income taxes paid on it.  Therefore, income taxes must be paid when the funds are withdrawn.  This tax burden makes these “tax heavy” assets less desirable for heirs.  But, it does not make these assets less desirable for tax-exempt organizations, because these organizations do not pay such taxes.  Therefore, it is always to the heirs’ advantage (and not to the disadvantage of charities) to make as much of the charitable share of estate assets as possible consist of traditional retirement accounts (i.e., qualified plan money).
Consider this simple example.  A donor has only two assets, a $1 million IRA and a $1 million house.  The donor wishes to leave half of her estate to a charity and half to her child.  The child earns a high income and is a resident of California.  Does it matter which asset the charity inherits and which asset the child inherits?
If the child inherits the home, the child will receive the $1,000,000 asset free from any taxation.  (There are no estate taxes because the donor’s estate is too small.)  The child can sell the asset and spend the entire $1,000,000.  The results are quite different if the child instead inherits the $1,000,000 traditional IRA.  The assets in the IRA have never had income taxes paid on them.  Thus, withdraws from the account will be treated as additional income to the child.  Assuming the child is paying the highest income tax rates at both the state (California) and federal levels, this leaves slightly more than half of the money available to the child after paying income taxes.  Notice that this massive difference in taxation occurs simply by the donor’s selection of which asset to give to charity.  The difference occurs even though the donor’s estate is not subject to estate taxes.  Although the difference would be less if the inheriting child were in a lower income tax bracket, it would still be substantial enough to warrant selecting the retirement assets instead of other assets for the charitable estate gift.

Retirement plan death beneficiaries are typically named in the beneficiary designation of the retirement account.  In other words, the donor’s will usually does not control the distribution of these assets.  (In fact, the will is best thought of as a back-up document in general because it will not control any assets with beneficiary designations or owned in joint ownership with right of survivorship.)  Good retirement plan beneficiaries include any public charity and any private foundation. 

Charitable Remainder Trusts (which are also charitable entities) may also make good beneficiaries, but with some additional considerations.  The unpaid income taxes on the retirement account funds will cause the retirement distribution to be considered “income in respect of a decedent”, a.k.a. IRD.  This IRD treatment is important in a Charitable Remainder Trust because it makes the retirement distribution funds ordinary income assets.  Ordinary income assets must be paid out first (i.e., Tier 1), prior to paying out any capital gain, non-taxable income or return of principal.  When paid out to non-charitable beneficiaries, the IRD will be taxable to the beneficiary as ordinary income.  Thus, to the extent that the retirement assets are ultimately paid to non-charitable beneficiaries, the tax advantages of leaving these assets to a charity disappear.  Another issue also arises regarding a potential income tax deduction.  Typically, if a beneficiary inherits an IRD asset, such as an IRA account, the beneficiary is entitled to an itemized income tax deduction in the amount of any estate taxes paid as a result of the transfer of the IRD asset.  For example, if Jane inherits a $100,000 IRA account which generated $40,000 of estate taxation (as compared to the estate taxes that would have been owed had the asset not existed), Jane will receive a $40,000 income tax deduction.  The idea here is to avoid taxation of dollars that have already been taken by the IRS in estate taxes.  In theory, this same deduction applies to the non-charitable portion of the Charitable Remainder Trust.  The estate pays estate taxes on the taxable portion of the IRA transfer to the Charitable Remainder Trust (i.e., the present value of the share that will not be going to charity).  These are estate taxes paid on IRD and thus generate an income tax deduction.  However, this tax deduction is treated as return of principal in the Charitable Remainder Trust, meaning that the deduction will not be distributed to the beneficiary unless all other ordinary income, capital gain income, and exempt income held in the trust is first paid out (see the chapter on Charitable Remainder Trust for Details).  The net effect of this is that the income tax deduction resulting from estate taxes paid on IRD will most likely be completely lost.

Problems can arise when naming a Charitable Lead Trust as beneficiary of a retirement account.  The Charitable Lead Trust is not a tax-exempt entity, thus it must pay income taxes when receiving the retirement account funds, just as any other taxpayer would (although perhaps at higher rates due to the compressed tax schedule of complex trusts). 

            Naming the estate as beneficiary, even if the estate will make charitable distributions, could result in the estate having to pay the income taxes on the retirement account funds.  This can arise if the account holder specifically names the estate as beneficiary or if no beneficiary is named, which will also cause the retirement account to pay to the account holder’s estate.  Typically, if the estate receives IRD (such as qualified plan money), the estate must pay the income taxes resulting from this IRD.  However, this can be avoided if the estate transfers the right to receive the IRD to fulfill a bequest of that specific item or of a share of the remaining estate.  In that case the recipient, not the estate, would owe the income taxes on the IRD.  If the recipient is a charity, no taxes will be owed.  This result is possible if the estate documents allow the executor to distribute assets on a non-pro rata basis (i.e., if the executor can send a disproportionate share of the IRD asset to the charitable beneficiary).  However, if the assets are used to fulfill dollar amount charitable bequests (i.e., estate gifts of specific dollar amounts), the estate will still have to pay the income taxes due from the IRD/retirement account asset. 

            Finally, if the retirement account is to be divided between charitable and non-charitable beneficiaries, the non-charitable beneficiaries have until the end of the next year following the decedent’s death to establish separate accounts for the charitable and non-charitable beneficiaries.  This is not necessary if the charity’s share is completely paid out prior to September 30 of the year following the decedent’s death.  Creating these separate accounts is important because if the charity is not paid off or separated out, it will reduce the maximum time allowed for the non-charitable beneficiaries to remove the funds (with income taxes being due at the time of removal).  These separate accounts may not be possible if the amount designated for charity was listed as a dollar amount, rather than a percentage amount.  However, such separation of accounts will not be needed if the administrator simply pays off the entire charitable portion prior to September 30 of the next year following the decedent’s death.  This complexity can also be avoided if the only other beneficiary is a spouse because a spouse can simply roll over his or her share into his or her separate IRA.

Naming someone other than the spouse as a beneficiary for an ERISA account, such as a 401(k), a SIMPLE IRA, a SEP IRA, an ESOP, or profit sharing plan, requires consent from the spouse.  Thus a charity may not be named as a primary beneficiary without the consent of the account holder’s spouse.  Such consent is not required in a traditional IRA or Roth IRA unless the company managing the accounts decides to add such requirements.

Estate gifts of retirement account assets, of course, require that the accounts have value after the death of the account holder.  Thus, traditional pension plans (i.e., defined benefit plans) are not directly relevant for charitable planning purposes because no valuable assets will survive the death of the participant (or, in some cases, the death of the participant and the participant’s spouse).
Because of their creation and administrative expenses, Charitable Remainder Trusts are generally reserved for substantial transfers of assets.  One way to conceptualize a qualified plan with a charitable beneficiary is like a mini-Charitable Remainder Trust with minimal administrative costs.  In both instruments the charity receives the assets at the death of the donor.  Both allow tax-free growth of assets and both can provide income to the donor.  In the Charitable Remainder Trust the income is fixed for life, whereas the qualified plan provides income at the discretion of the donor (and without a 10% penalty after age 59 ½).  The Charitable Remainder Trust reduces income by the share of the transfer representing the present value of the charitable interest.  The qualified retirement plan reduces income by the entire amount of the transfer for qualified taxpayers.  Of course a retirement account can be funded only with cash and there are limits to the amount of funding allowed.  The Charitable Remainder Trust can be of unlimited size and can be funded with appreciated assets and thereby postpone or eliminate the associated capital gains tax.  In cases where a donor is attracted to the features of a Charitable Remainder Trust, but where the nature and size of the potential gift does not warrant its use, it may be helpful to consider naming a charity as a qualified plan beneficiary as a type of mini-Charitable Remainder Trust substitute.
A final area where charitable planning can connect with retirement accounts is in managing the tax consequences of Roth IRA conversions.  The goal here is to match a spike in income, caused by a Roth IRA conversion, with a simultaneous spike in charitable deductions.
The idea of a Roth conversion is to change a traditional IRA into a Roth IRA.  A traditional IRA grows tax free, but income taxes must be paid whenever distributions are taken from the account.  In a Roth IRA, taxes are paid on the initial contributions, but no taxes need to be paid when qualified distributions are taken from the account, regardless of whether the distributions were of initial contributions or subsequent growth on those initial contributions.  Converting a traditional IRA into a Roth IRA causes the account holder to be charged with income taxes on the amount of conversion less any basis in the traditional IRA.  (Basis in a traditional IRA consists of amounts originally contributed with after tax funds, i.e., contributed with no deduction.)  In exchange for this tax disadvantage, the account holder gains the ability to take future qualified distributions free from income taxes, whether those distributions are from the converted assets or from subsequent growth on those converted assets.  Thus, the extra tax benefit is the income tax free receipt of future growth on the Roth IRA assets.  Although acquiring the benefits from such a conversion may make perfect sense in the context of an overall retirement plan, it can generate a substantial immediate spike in taxable income.  Because there are no limits on the amount of an IRA that can be converted to a Roth IRA, the amount of this spike in income can be dramatic relative to the account holder’s normal income.
This spike in income may make the account holder particularly interested in generating income tax deductions.  First, this may be true because the increased income resulting from the Roth IRA conversion may temporarily push the account holder into a higher income tax bracket.  Thus, deductions taken in the year of the conversion will be more valuable than deductions taken in a later year.  (The value of a deduction is the amount of the deduction multiplied by the taxpayer’s marginal tax rate.  Therefore, a higher tax rate makes the deductions more valuable.)  Additionally, the taxpayer may wish to pursue a larger conversion but may not have enough cash to pay for the resulting tax consequences.  Deductions could reduce the costs of the tax consequences of the Roth conversion, allowing the cash-limited account holder to convert a larger amount into the Roth account.
Of course, much of charitable planning is designed to provide creative ways to generate charitable income tax deductions, making charitable planning a natural fit with Roth IRA conversion.  Thus, a donor might move assets or cash into a Charitable Remainder Trust, grantor Charitable Lead Trust, Charitable Gift Annuity, donor advised fund or private foundation.  Such charitable planning may permit a large immediate deduction even where the donor does not wish to sell the underlying asset (such as with a Charitable Remainder Trust, grantor Charitable Lead Trust, or Private Foundation), or where the donor wishes to receive income from the underlying asset (such as with a Charitable Remainder Trust or Charitable Gift Annuity), or where the donor wishes to receive the asset back after a period of time (such as with a grantor Charitable Lead Trust).  Finally, the donor who has neither the cash nor the desire to transfer assets in order to generate a charitable income tax deduction may consider gifting a remainder interest in a personal residence or farmland.  This gifting of the inheritance rights to the property generates an immediate, potentially very large, deduction with no requirement for immediate cash or loss of income from or use of the underlying real estate.
Of course, the use of charitable deductions is not unlimited and depending on the gift type and the recipient type such deductions are limited to 20%, 30%, or 50% of income.  Thus, charitable deductions cannot completely offset a spike in income of unlimited size.  However, the ability to reduce income by up to 50% is still a potentially powerful tool.  When these income limitations are exceeded, charitable deductions can be carried forward into future years.  However, after five additional years these deductions will expire.
A donor may have substantial charitable deductions that, due perhaps to a large transfer of assets, exceed the income giving limitations for one year or even for all five carryover years.  Especially in cases where these deductions would otherwise expire, there may be interest in pulling income from future years, so that the deductions can be used.
A perfect way to accomplish the task of pulling income back from future years is to convert some funds from a traditional IRA into a Roth IRA.  The conversion results in pre-paying taxes that would otherwise be due later and subsequently allows for tax-free growth following the conversion.  Consequently, paying taxes for the conversion can be a wise investment.  This investment is made all the more beneficial if it can be partially paid for with charitable tax deductions that, otherwise, would have expired unused.
In this way Roth conversions and charitable deductions can work together to help match income with deductions.  When income is temporarily high, due to any cause including a Roth conversion, charitable deductions become temporarily more valuable due to higher marginal tax rates.  The use of charitable deductions can reduce the immediate tax costs associated with a Roth conversion.  When excessive charitable deductions might otherwise go unused due to income limitations, a Roth conversion can provide the temporary spike in income that allows for the deductions to be used.
Working with retirement assets is important simply because of the magnitude of household wealth held in such instruments.  Additionally, it is useful to have a basic understanding of the options because the results from charitable giving from such funds can have tax consequences ranging from absolutely awful to absolutely wonderful.  The well advised donor will successfully avoid the former and embrace the latter.

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Re: 15. Donating Retirement Assets, Part 2 of 2

Are there restrictions on listing your own employer if a non-profit as a secondary beneficiary?

Re: 15. Donating Retirement Assets, Part 2 of 2

I haven't run across any restrictions, but maybe someone else will have other experiences. Typically the 401(k), 403(b), etc. would be administered by an outside financial institution, although it does make me wonder if additional concerns could arise if the plan was administered internally. Are there any particular areas of concern you think might be an issue here?

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